he following quote from C. Edward Griffin tells the little known story how dollars are created.
The Mandrake Mechanism
The American dollar has no intrinsic value. It is a classic example of fiat money with no limit to the quantity that can be produced. Its primary value lies in the willingness of people to accept it and, to that end, legal tender laws require them to do so. It is true that our money is created out of nothing, but it is more accurate to say that it is based upon debt. In one sense, therefore, our money is created out of less than nothing. The entire money supply would vanish into bank vaults and computer chips if all debts are repaid. Under the present System, therefore, our leaders cannot allow a serious reduction in either the national or consumer debt. Charging interest on pretended loans is usury, and that has become institutionalized under the Federal Reserve System. The Mandrake Mechanism by which the Fed converts debt into money may seem complicated at first, but it is simple if one remembers that the process is not intended to be logical but to confuse and deceive. The end product of the Mechanism is artificial expansion of the money supply, which is the root cause of the hidden tax called inflation. The expansion then leads to contraction and, together, they produce the destructive boom-bust cycle that has plagued mankind throughout history wherever fiat money has existed.
I recently listened to a podcast with some all-star [there are awards for everything now] “Black Box” equity trader. It was quite a “telling” interview & I thank him for his insights but I’d heard it all before. His confidence was staggering considering the general unpredictability of the future and, of course, the equity markets. He explained how he had completely converted from a generally unsuccessful, discretionary technical trading style to a purely quantitative and scientific trading mode. He seemed to be so excited that his models, according to him, were pretty much “bullet proof”. Having had more than just some tangential experience with black box modeling and trading myself I thought … you know … some people will just never learn.
Image via iwatchapple.it
You see some years ago I was particularly focused on quantitative investing. Basically, “screw” the fundamentals and exclusively concentrate on price trends/charts and cross security/asset correlations [aka “Black Box” trading]. I was fascinated with the process and my results were initially stellar [high absolute returns with Sharpe Ratios > 2.0]. And, after looking at the regression data many others agreed. I was in high demand. So I “made the rounds” in Manhattan and Greenwich to a group of high profile hedge funds. It was a very exciting time for me as the interest level was significant.
As it turned out I had the good fortune of working with one of the world’s largest and best performing hedge funds. Their black box modeling team had been at it for years … back-testing every conceivable variable from every perceived angle … twisted/contorted in every conceivable/measurable manner … truly dedicated to the idea that regression tested, quantitative trading models were the incremental/necessary “edge” to consistently generate alpha while maximizing risk-adjusted, absolutely positive returns. We worked together for some time and I became intimately involved with their quantitative modeling/trading team … truly populated with some of the best minds in the business.
While in Greenwich Ct. one afternoon I will never forget a conversation I had with a leading quantitative portfolio manager. He said to me that despite its obvious attributes “Black Box” trading was very tricky. The algorithms may work for a while [even a very long while] and then, inexplicably, they’ll just completely “BLOW-UP”. To him the most important component to quantitative trading was not the creation of a good model. To him, amazingly, that was a challenge but not especially difficult. The real challenge, for him, was to “sniff out” the degrading model prior to its inevitable “BLOW-UP”.
And I quote his humble, resolute observation:
“because, you know, eventually they ALL blow-up“
… as most did in August 2007.
It was a “who’s who” of legendary hedge fund firms that had assembled “crack” teams of “Black Box” modelers: Citadel, Renaissance, DE Shaw, Tudor, Atticus, Harbinger and so many Tiger “cubs” including Tontine [not all strictly quantitative but, at least, dedicated to the intellectual dogma] … all preceded by Amaranth in 2006 and the legendary Long Term Capital Management’s [“picking up pennies in front of a steam-roller“] demise one decade earlier.
Years of monthly returns with exceedingly low volatility were turned “inside out” in just 4-6 weeks as many funds suffered monthly losses > 20% which was previously considered highly improbable and almost technically impossible … and, voilà … effectively, a sword was violently thrust through the heart of EVERY “Black Box” model. VaR and every other risk management tool fell victim to legitimate liquidity issues, margin calls and sheer human panic.
Many of these firms somehow survived but only by heavily gating their, previously lightly-gated, quarterly liquidity provisions. Basically, as an investor, you could not “get out” if you wanted to. These funds changed the liquidity rules to suit their own needs … to survive … though many did fail.
Anyway … to follow up on my dialogue with the esteemed portfolio manager … I asked “why do they all “BLOW-UP”? What are those common traits that seem to effect just about every quantitative model despite the intellectual and capital fire-power behind them? And if they all eventually “BLOW-UP” then why are we even doing this?”
He answered the second part of the question first … and I paraphrase …
“We are all doing this because we can all make a lot of money BEFORE they “BLOW-UP”. And after they do “BLOW-UP” nobody can take the money back from us.” He then informed me why all these models actually “BLOW-UP”. “Because despite what we all want to believe about our own intellectual unique-ness, at its core, we are all doing the same thing. And when that occurs a lot of trades get too crowded … and when we all want to liquidate [these similar trades] at the same time … that’s when it gets very ugly.“.
I was so naive. He was so right.
Exactly What Were We All Doing?
We all knew what the leaders wanted and, of course, we wanted to please them. Essentially they wanted to see a model able to generate 4-6% annual returns [seems low, I know, but I’ll address that later] … with exceptionally low volatility, slim draw-down profiles and winning months outweighing the losing months by about 2:1. They also wanted to see a model trading exceptionally liquid securities [usually equities].
Plus the model, itself, had to be completely scientific with programmable filtering and execution [initiation and liquidation] features so that it could be efficiently applied and, more importantly, stringently back-tested and stress-tested . Long or short did not really matter. Just make money within the parameters. Plus, the model had to be able to accommodate at least $100M [fully invested most of the time as cash was not an option] and, hopefully, much more capital. This is much easier said than done but, given the brainpower and financial resources, was certainly achievable.
This is what all the “brainpower” learned … eventually.
First of all, a large number of variables in the stock selection filter meaningfully narrowed the opportunity set … meaning, usually, not enough tickers were regularly generated [through the filter] to absorb enough capital to tilt the performance meter at most large hedge funds…as position size was very limited [1-2% maximum]. The leaders wanted the model to be the hero not just a handful of stocks. So the variables had to be reduced and optimized. Seemingly redundant indicators [for the filter] were re-tested and “tossed” and, as expected, the reduced variables increased the population set of tickers … but it also ramped the incremental volatility … which was considered very bad. In order to re-dampen the volatility capital limits on portfolio slant and sector concentration, were initiated. Sometimes market neutral but usually never more than net 30% exposure in one direction and most sectors could never comprise more than 5% of the entire portfolio. We used to joke that these portfolios were so neutered that it might be impossible for them to actually generate any meaningfully positive returns. At the time of “production” they actually did seem, at least as a model, “UN-BLOW-UP-ABLE” considering all the capital controls, counter correlations and redundancies.
Another common trait of these models that was that, in order to minimize volatility, the holding periods had to be much shorter than a lot of us had anticipated. So execution [both initiation and liquidation] became a critical factor. Back then a 2-3 day holding period was considered acceptable, but brief, although there were plenty of intra-day strategies … just not at my firm … at least not yet. With these seemingly high velocity trading models [at the time], price slippage and execution costs, became supreme enemies of forecasted returns. To this day the toughest element to back-testing is accessing tick data and accurately pinpointing execution prices. Given this unpredictability, liberal price slippage was built into every model … and the model’s returns continued to compress … not to mention the computer time charges assessed by the leadership [which always pissed me off].
So, given all of this, what types of annual returns could these portfolios actually generate? A very good model would generate a net 5-7% … but 3.5-5% was acceptable too. So how then could anybody make any real money especially after considering the labor costs to construct/manage/monitor these models … which … BTW … was substantial?
Of course there was only one real way … although it would incrementally cut into performance even more, in the near term, but ultimately pay off if the “live” model performed as tested. The answer = LEVERAGE … and I mean a lot of it … as long as the volatility was low enough.
Back-tested volatility was one thing and live model volatility was another thing so leverage was only, ever so slowly, applied … but as time passed and the model performed, the leverage applied would definitely increase. Before you knew it those 5% returns were suddenly 20-25% returns as the positive beauty of leverage [in this case 4-5x] was unleashed.
Fast forward 10 years and the objectives of hedge funds are still the same. Generate positive absolute returns with low volatility … seeking the asymmetrical trade … sometimes discretionary but in many cases these “Black Box” models still proliferate. And BTW … they are all “doing the same thing“ as always … current iteration = levered “long” funds.
What has changed though is the increased dollars managed by these funds [now > $3.5T] and the concentration, of these dollars, at the twenty largest funds [top heavy for sure]. What has also considerably changed is the cost of money … aka leverage. It is just so much cheaper … and, of course, is still being liberally applied but, to reiterate, in fewer hands.
Are these “hands” any steadier than they were ten years ago? I suppose that is debate-able but my bet is that they are not. They are still relying on regression-ed and stress tested data from the past [albeit with faster computers & more data]. They may even argue that their models are stronger due to the high volatility markets of ’08/’09 that they were able to survive and subsequently measure, test and integrate into their current “Black Boxes” … further strengthening their convictions … which is the most dangerous aspect of all.
Strong Conviction … aka Over Confidence +
Low Volatility +
High Levels/Low Costs of Leverage [irrespective of Dodd-Frank] +
More Absolute Capital at Risk +
Increased Concentration of “At Risk” Capital +
“Doing the Same Thing”
… Adds up to a Combustible Market Cocktail.
Still a catalyst is needed and, as always, the initial catalyst is liquidity [which typically results in a breakdown of historic correlations as the models begin to “knee-bend” … and the perceived safety of hedges is cast in doubt] followed by margin calls [the ugly side of leverage … not to mention a whole recent slew of ETF’s that are plainly levered to begin with that, with the use of borrowed money, morph into “super-levered” financial instruments] and concluding with the ever ugly human panic element [in this case the complete disregard for the “black box” models even after doubling/trebling capital applied on the way down because the “black box” instructed you to]. When the “box” eventually gets “kicked to the curb” … that is when the selling ends … but not after some REAL financial pain.
So can, and will, this really occur once again? It can absolutely occur but it is just impossible to know exactly when … although there are plenty of warning signs suggesting its likelihood … as there have been for some time.
However, I am quite confident of the following:
The Fed Is Clueless On All Of This
[just too many moving parts for them … they cannot even coordinate a simple “cover-up” of leaked monetary policy … so no way the academics can grasp any of this … just liked they missed LTCM. Nor it seems…do they have any interest in it as it is too tactical for a strategically inclined central banker].
“Eventually They ALL Blow-Up”
The Only Real Question Left To Answer = HOW BIG CAN THIS POSSIBLE “BLOW-UP” ACTUALLY BE? I think … if the pieces simultaneously shudder … then pretty BIG
Will there be a coal industry over the next few decades in order to determine whether to use liquidation or going-concern value?
We seek to buy cyclical assets when there are NO REASONS to buy, the companies in the industry have depressed profits or large losses, and there seems to be no hope for the industry (Remember Airlines 9/11). However, we wish to avoid investing in Canal companies during the advent of the steam locomotive because then there is a permanent decline in asset value because long-term cash flows are driven by capacity constraints and customer demand changes. Thus, we first try to answer this post’s question.
Let’s break down the energy producing statistics.
According to the Independent Statistics and Analysis Energy Information Administration, here’s how the nation’s electricity was generated in 2014:
■ Coal: 38 percent
■ Natural gas: 27 percent
■ Nuclear: 19 percent
■ Hydropower: 6 percent
■ Other renewables: 7 percent, including
— Biomass: 1.7 percent
— Geothermal: 0.4 percent
— Solar: 0.4 percent
— Wind: 4.4 percent
— Other gases: 1 percent
So let’s take the 38 percent of coal production out of the mix. Where’s the energy going to come from? It’s not. Therefore, we’re left with nothing but periods of darkness.
Long dismissed as a relic of a bygone era, coal is back — with a vengence. Coal is one of the nation’s biggest and most influential industries — Big Coal provides more than half the electricity consumed by Americans today (2006) — and its dominance is growing, driven by rising oil prices and calls for energy independence. Is coal the solution to America’s energy problems?
On close examination, the glowing promise of coal quickly turns to ash. Coal mining remains a deadly and environmentally destructive industry. Nearly forty percent of the carbon dioxide released into the atmosphere each year comes from coal-fired power plants. In the last two decades, air pollution from coal plants has killed more than half a million Americans. In this eye-opening call to action, Goodell explains the costs and consequences of America’s addiction to coal and discusses how we can kick the habit.
We need fossil fuels
Current policies to supplant fossil fuels with inferior energy sources need to incorporate a deeper understanding of the transformative role of energy in human society lest they jettison the wellsprings of mankind’s greatest advance.
The thesis of this paper is that fossil fuels, as a necessary condition of the Industrial Revolution, made modern living standards possible and vastly improved living conditions across the world. Humanity’s use of fossil fuels has released whole populations from abject poverty. Throughout human history, elites, of course, have enjoyed comfortable wealth. No more than 200 years ago, however, the lives of the bulk of humanity were “poor, nasty, brutish and short,” in the words memorably used by Thomas Hobbes.
This paper aims to articulate and explain some startling, but rarely acknowledged, facts about the role of energy in human history. Energy is so intimately connected to life itself that it is almost equivalent to physical life. Virtually everything needed to sustain the life of a human individual—food, heat, clothing, shelter—depends upon access to and conversion of energy. Modern, prosperous nations now access a seemingly limitless supply of energy. This cornucopia, however, is a very recent advance in mankind’s history. Fossil fuels, methodically harnessed for the first time in the English Industrial Revolution, beginning in the 18th century and taking off in the 19th century, have been a necessary condition of prosperous societies and of fundamental improvements in human well-being.
Adequate treatment of this topic is a daunting task for anyone. The unprecedented stakes in today’s contentious energy policy debates about carbon, however, make it a morally necessary topic. As a former final decision-maker in a large environmental regulatory agency, I urge current officials and concerned citizens to reflect on energy policies within a broad but fundamental context: human history and the physics of material lives.
My research was initially inspired by a comprehensively researched monograph by Indur Goklany titled “Humanity Unbound.” His paper took me to a dozen books and twice as many academic papers. With gratitude, I acknowledge the books listed below as the most enlightening, persuasive guides on the topic. And I highly recommend them for more thorough analysis than allowed by the confines of this paper. May those policymakers entrusted with the authority to make binding decisions about energy consider these books as “a look before an unreflective leap” that could unravel mankind’s greatest achievement—
the potential enjoyment of long, comfortable, healthy lives without the gnawing hunger of subsistence poverty.
Yes, fossil fuels have fueled our progress through the industrial revolution into the information age. But we have over-used them and fouled our nest. We could and can shift rapidly to renewables, but big oil greed obstructs us.(Really?) As Pope Francis says, we have made the earth into “an immense pile of filth.” Own it.
The first big flaw that tragically happens to be the binding of the entire book (and in the title) is his thesis that fossil fuels is what causes human flourishing. No. INDUSTRIALIZATION is the underlying mechanism hat has created the exponential increase in human progress. Fossil fuels was just the first way of converting potential energy to mechanical energy. And it was a good one, but we need to move on to a more advance potential energy source. Luckily exponential growth in renewables and other advanced technologies has just started to gain heavy heavy steam.
As an actual Ph.D. geoscientist who HAS WORKED for oil companies, written textbooks in geology of oil, and also done actual published research in climate change in peer-reviewed journals, I can say this work is pure garbage. Epstein cherry-picks climate data he doesn’t understand (as the review by Kathy Moyd pointed out), denies the conclusions of an entire scientific community who are NOT paid to shill for industry, and denies the obvious evidence of climate change going on worldwide. Then he distorts the benefits of fossil fuels and neglects or underplays the problems. The biggest problem of all is that (as all of us who are in the industry know so well), we’re past the peak of Hubbert’s curve and oil isn’t going to be cheap for the uses he brags about much longer.(CSInvesting: Whether fact-based, true or untrue, all this critic asserts is not backed up with evidence–an assertion is not an argument.) Appeal to authority argument–I’m in the industry and brilliant, you’re an idiot, so listen up!
Once the Saudis stop flooding the market with cheap oil to drive out the competition, it will pick up again to the levels of demand that anyone in the oil futures business knows so well, and we’ll be unable to use it for cheap plastics, fertilizers, pesticides, and all the other stuff that we wasted nearly all the planet’s oil heritage on. The moral case is clearly that we need to wean ourselves OFF of using up the last remaining oil so quickly before it reaches its true levels of scarcity, and it’s irresponsible to encourage people to use it up faster.
As all of my co-workers in the oil industry (and the students I trained who are now high in the business as well) know, oil is getting scarcer and scarcer, and the last thing we need to do is use it up faster and crash the global economy. Most of my colleagues in oil also agree that climate change is a serious problem–even though the bosses at ExxonMobil and Koch are bankrolling the climate denial lobby. Before you believe garbage by an industry hack with no actual training in the field, listen to those of us INSIDE the industry and INSIDE the climate science community. Our future is at stake when we make bad decisions based on crummy books like this! (CSInvesting: I am an expert, therefore all my assertions are correct. What’s to argue? What better way to move to renewable energy than to let the free market decide to price oil at $1,000 a barrel–therefore making nuclear or hydro power more economic).
Environmentalists are evil: George Reisman-
Here’s David M. Graber, in his prominently featured Los Angeles Times book review of Bill McKibben’s The End of Nature: “McKibben is a biocentrist, and so am I (See video of debate below). We are not interested in the utility of a particular species or free-flowing river, or ecosystem, to mankind. They have intrinsic value, more value—to me—than another human body, or a billion of them.… It is cosmically unlikely that the developed world will choose to end its orgy of fossil-energy consumption, and the Third World its suicidal consumption of landscape. Until such time as Homo sapiens should decide to rejoin nature, some of us can only hope for the right virus to come along.”
And here’s Prince Philip of England (who for sixteen years was president of the World Wildlife Fund): “In the event that I am reincarnated, I would like to return as a deadly virus, in order to contribute something to solve overpopulation.” (A lengthy compilation of such statements, and worse, by prominent environmentalists can be found at Frightening Quotes from Environmentalists.)
There is no negative reaction from the environmental movement because what such statements express is nothing other than the actual philosophy of the movement. This is what the movement believes in. It’s what it agrees with. It’s what it desires. Environmentalists are no more prepared to attack the advocacy of mass destruction and death than Austrian economists are prepared to attack the advocacy of laissez-faire capitalism and economic progress. Mass destruction and death is the goal of environmentalists, just as laissez-faire capitalism and economic progress is the goal of Austrian economists.
And this is why I call environmentalism evil. It’s evil to the core. In the environmental movement, contemplating the mass death of people in general is no more shocking than it was in the Communist and Nazi movements to contemplate the mass death of capitalists or Jews in particular. All three are philosophies of death. The only difference is that environmentalism aims at death on a much larger scale.
Despite still being far from possessing full power in any country, the environmentalists are already responsible for approximately 96 million deaths from malaria across the world. These deaths are the result of the environmentalist-led ban on the use of DDT, which could easily have prevented them and, before its ban, was on the verge of wiping out malaria. The environmentalists brought about the ban because they deemed the survival of a species of vultures, to whom DDT was apparently poisonous, more important than the lives of millions of human beings.
The deaths that have already been caused by environmentalism approximate the combined number of deaths caused by the Nazis and Communists.
If and when the environmentalists take full power, and begin imposing and then progressively increasing the severity of such things as carbon taxes and carbon caps, in order to reach their goal of reducing carbon dioxide emissions by 90 percent, the number of deaths that will result will rise into the billions, which is in accord with the movement’s openly professed agenda of large-scale depopulation. (The policy will have little or no effect on global mean temperatures, the reduction of which is the rationalization for its adoption, but it will have a great effect on the size of human population.)
It is not at all accidental that environmentalism is evil and that its leading spokesmen hold or sanction ideas that are indistinguishable from those of sociopaths. Its evil springs from a fundamental philosophical doctrine that lies at the very core and deepest foundations of the movement, a doctrine that directly implies the movement’s destructiveness and hatred of the human race. This is the doctrine of the alleged intrinsic value of nature, i.e., that nature is valuable in and of itself, apart from all connection to human life and well being. This doctrine is accepted by the movement without any internal challenge, and, indeed, is the very basis of environmentalism’s existence.
As I wrote in Capitalism, “The idea of nature’s intrinsic value inexorably implies a desire to destroy man and his works because it implies a perception of man as the systematic destroyer of the good, and thus as the systematic doer of evil. Just as man perceives coyotes, wolves, and rattlesnakes as evil because they regularly destroy the cattle and sheep he values as sources of food and clothing, so on the premise of nature’s intrinsic value, the environmentalists view man as evil, because, in the pursuit of his well-being, man systematically destroys the wildlife, jungles, and rock formations that the environmentalists hold to be intrinsically valuable. Indeed, from the perspective of such alleged intrinsic values of nature, the degree of man’s alleged destructiveness and evil is directly in proportion to his loyalty to his essential nature. Man is the rational being. It is his application of his reason in the form of science, technology, and an industrial civilization that enables him to act on nature on the enormous scale on which he now does. Thus, it is his possession and use of reason—manifested in his technology and industry—for which he is hated.”
Thus these are the reasons that I think it is necessary for people never to describe themselves as environmentalists, that to do is comparable to describing oneself as a Communist or Nazi. Doing so marks one as a hater and enemy of the human race.
Why does high growth seem to depress stock market returns and low growth seem to generate high stock market returns? It is not the growth destroys returns, but that the market already recognizes the high-growth nation’s potential, and bids the price of its equities too high. Market participants become overly optimistic during periods of high growth, driving up the prices of stocks and lowering long-term returns, and become too pessimistic during busts, selling down stocks and creating the conditions for high long-term returns. Jay Ritter says that irrationality generates volatility “and mean reversion over multi-year horizons.” Graham would agree (p. 88, DEEP VALUE).
The implications for mean reversion in stocks are counter-intuitive. Stocks with big market price gains and historically high rates of earnings growth tend to grow earnings more slowly in the future, and underperform the market. Stocks with big market prices losses and historically declining earnings tend to see their earnings grow faster, and out perform the market. Undervalued stocks with historically declining earnings grow earnings faster than overvalued stocks with rapidly increasing earnings. This is mean reversion, and, as Ben Graham said, it’s the phenonmenon that leads value strategies to beat the market.
The update to Lakonishok’s research Contrarian Investments Extrapolation and Risk demonstrates that, aside from short periods of under-performance, value stocks generate a consistent value premium, and beat both the market and glamour stocks over the long haul. ….Researchers believe the reasons are because they are contrarian to overreaction and naive extrapolation. Efficient market academics Eugene Fama and Ken French, counter that value strategies outperform because they are riskier. However, Lakonishok found that while value strategies do disproportionately well in good times, its performance in bad times is also impressive. Value strategies are also outperform during “bad” states for the world such as recession and extreme down markets.
When Lakonishok compared the growth rates implied by the market price to the actual growth rates appearing after the selection date, they found a remarkable result–one that supports Graham’s intuition–value stocks grow fundamentals faster than glamour stocks. The high prices paid for glamour stocks imply that the market expects them to generate high rates of growth. Contrary to this expectation, however, the growth rates do not persist. Growth stocks;s growth rates mean-revert from fast growth to slow growth.
If you read all the links and research papers in the past two posts for this chapter in DEEP VALUE, you know that:
Out-of-favor value stocks beat glamour stocks because….
the actual growth rates of fundamental sales and earnings of glamour stocks relative to value stocks after selection are much lower than they were in the past, or as the multiples on those stocks indicate the market expects them to be.
Value strategies appear to be less risky than glamour strategies.
So why do investors persist in buying glamour? For behavioral reasons like anchoring and “overreaction bias.” We will next explore chapter 6 in Deep Value.
Let’s go back to DEEP VALUE, Chapter 5: A Clockwork Market: Mean reversion and the Wheel of Fortune.
As a value investor you are doing either:
Buying a franchise, where barriers to entry allow for profitable growth, before mean reversion sets in or
Buying assets where the normalized earnings’ power of those assets is below norm (Asset value = Earnings Power Value) and earnings’ power will mean revert to normal.
Therefore the concept of Regression to the Mean is powerful. By putting the words, “Many shall be restored that now are fallend and many shall fall that now are in honor” on the facing page of Security Analysis, Graham gave the most prominent position in his seminal text to the idea that Fortuna’s wheel turns too for securities, lowering those that have risen and lifting those that have fallen. The line, from Horace’s Ars Poetica, echoes the phrase spoken by the wise men of legend who boiled down the history of mortal affairs into the four words, “This too will pass.” This is regression toward the mean. (p. 79).
The more extreme the initial price movement, the greater will be the subsequent adjustment in the opposite direction. There tends to be a price trend before reversal. The reasons are manifold, but the most obvious is that the trials aren’t independent—our own trading decisions are affected by the buying or selling preceding our trade.
Two economists known for research into both market behavior and individual decision-making, Werner De Bondt and Richard Thaler, theorized that it is this overreaction to meaningless price movements that creates the conditions for mean reversion. Note page 800 in the link Does Stock Market Overreact— the loser and winner portfolios. Losers win out.
In a second study, Further Evidence of Inv Overreaction Thaler, Thaler and De Bondt revisited the research from a new perspective. They hypothesized that the mean reversion they obserbed in stock prices in the first study might have been caused by investors focusing too much on the short-term. this fixation on the recent past and failure to look beyond the immediate future would cause investors to miscalculate future earnings by failing to account for mean reversion. If earnings were also mean reversing, then extreme stock price increases and decreases might, paradoxically, be predictive of mean-reversion not just in stock prices, but in earnings too. A stock price that has fallen a great deal becomes a good candidate for subsequent earnings growth, a vice versa for a stock price that has gone up a lot. As you can see from the two research reports that the undervalued portfolio delivered better earnings and price performance.
The above research stand the conventional wisdom on its head and show compelling evidence for mean reversion in stocks in a variety of forms.
Buffett Discusses Mean Reversion in the Stock Market
In the 1964 to 1981 period, Buffett wrote, U.S. GNP almost quintuples, rising 373 percent. The market, by contrast, went nowhere.
The evidence is that valuation, rather than economic growth, determines investment returns at the market and country level. Research suggests that chasing growth economies is akin to chasing overvalued stocks, and generates disappointing results. See
The growth illusion
WHEN investors pick the countries they want to back, they tend to be guided by economic growth prospects. The faster an economy grows, they reason, the faster corporate profits will grow in the country concerned, and thus the higher the returns investors will achieve.
Alas, this is not the case. Work done by Elroy Dimson, Paul Marsh and Mike Staunton at the London Business School established this back in 2005. Over the 17 countries they studied, going back to 1900, there was actually a negative correlation between investment returns and growth in GDP per capita, the best measure of how rich people are getting. In a second test, they took the five-year growth rates of the economies and divided them into quintiles. The quintle of countries with the highest growth rate over the previous five years, produced average returns over the following year of 6%; those in the slowest-growing quintile produced returns of 12%. In a third test, they looked at the countries and found no statistical link between one year’s GDP growth rate and the next year’s investment returns.
Why might this be? One likely explanation is that growth countries are like growth stocks; their potential is recognised and the price of their equities is bid up to stratospheric levels. The second is that a stockmarket does not precisely represent a country’s economy – it excludes unquoted companies and includes the foreign subsidiaries of domestic businesses. The third factor may be that growth is siphoned off by insiders – executives and the like – at the expense of shareholders.
Paul Marson, the chief investment officer of Lombard Odier, has extended this research to emerging markets. He found no correlation between GDP growth and stockmarket returns in developing countries over the period 1976-2005. A classic example is China; average nominal GDP growth since 1993 has been 15.6%, the compound stockmarket return over the same period has been minus 3.3%. In stodgy old Britain, nominal GDP growth has averaged just 4.9%, but investment returns have been 6.1% per annum, more than nine percentage points ahead of booming China.
What does work? Over the long run (but not the short), it is valuation; the higher the starting price-earnings ratio when you buy a market, the lower the return over the next 10 years. That is why buying shares back in 1999 and 2000 has provided to be such a bad deal.
High Growth Depresses Future Stock Returns
Why does high growth seem to depress stock market returns and low growth seem to generate high stock market returns? The market ALREADY recognizes the high growth nation’s potential, and bids the price of its equities too high. Market participants become overly optimistic during periods of high growth, driving up the prices of stocks and lowering long term returns, and become too pessimistic during busts, selling down stocks and creating e conditions for high long-term returns. More research on that here:
I will finish this chapter in the next post. If you do not have DEEP VALUE or Quantitative Value, then join the deep value group found here: http://csinvesting.org/2015/01/14/deep-value-group-at-google/ and I will send.
If you only understand one concept besides Margin of Safety in investing then let it be Reversion to the Mean.
Silver FeverEvidence of bubbles has accelerated since the [2007-2009 financial] crisis. ~ Robert Shiller (“Irrational Exuberance,” 2015).The celebrated author and humorist Samuel Clemens (pen name Mark Twain) documented his experiences in the Nevada mining stock bubble, and his writings are one of the earliest (and certainly the most humorous) firsthand accounts of involvement in a speculative mania.
After a brief stint as a Confederate militiaman during the beginning of the U.S. Civil War, Clemens purchased stagecoach passage west, to Nevada, where his brother had been appointed Secretary of the Territory. In Nevada, Clemens began working as a reporter in Virginia City, in one of Nevada’s most productive silver- and gold-mining regions. He enviously watched prospecting parties departing into the wilderness, and he quickly became“smitten with the silver fever.”
Clemens and two friends soon went out in search of silver veins in the mountains. As Clemens tells it, they rapidly discovered and laid claim to a rich vein of silver called the Wide West mine. The night after they established their ownership, they were restless and unable to sleep, visited by fantasies of extravagant wealth: “No one can be so thoughtless as to suppose that we slept, that night. Higbie and I went to bed at midnight, but it was only to lie broad awake and think, dream, scheme.”
Clemens reported that in the excitement and confusion of the days following their discovery, he and his two partners failed to begin mining their claim. Under Nevada state law, a claim could be usurped if not worked within 10 days. As they scrambled, they didn’t start working, and they lost their claim to the mine. His dreams of sudden wealth were momentarily set back.
But Clemens had a keen ear for rumors and new opportunities. Some prospectors who found rich ore veins were selling stock in New York City to raise capital for mining operations. In 1863, Clemens accumulated stocks in several such silver mines, sometimes as payment for working as a journalist. In order to lock in his anticipated gains from the stocks, he made a plan to sell his silver shares either when they reached $100,000 in total value or when Nevada voters approved a state constitution (which he thought would erode their long-term value).
In 1863, funded by his substantial (paper) stock wealth, Clemens retired from journalism. He traveled west to San Francisco to live the high life. He watched his silver mine stock price quotes in the newspaper, and he felt rich: “I lived at the best hotel, exhibited my clothes in the most conspicuous places, infested the opera. . . . I had longed to be a butterfly, and I was one at last.”
Yet after Nevada became a state, Clemens continued to hold on to his stocks, contrary to his plan. Suddenly, the gambling mania on silver stocks ended, and without warning, Clemens found himself virtually broke.
“I, the cheerful idiot that had been squandering money like water, and thought myself beyond the reach of misfortune, had not now as much as fifty dollars when I gathered together my various debts and paid them.”
Clemens was forced to return to journalism to pay his expenses. He lived on meager pay over the next several years. Even after his great literary and lecture-circuit success in the late nineteenth century, he continued to have difficulty investing wisely. In later life he had very public and large debts, and he was forced to work, often much harder than he wanted, to make ends meet for his family.
Clemens had made a plan to sell his silver stock shares when Nevada became a state. His rapid and large gains stoked a sense of invincibility. Soon he deviated from his stock sales plan, stopped paying attention to the market fundamentals, and found himself virtually broke.
Clemens was by no means the first or last person to succumb to mining stock excitement. The World’s Work, an investment periodical published decades later, in the early 1900s, was beset by letters from investors asking for advice on mining stocks. The magazine’s response to these letters was straightforward: “Emotion plays too large a part in the business of mining stocks. Enthusiasm, lust for gain, gullibility are the real bases of this trading. The sober common sense of the intelligent businessman has no part in such investment.” (from Meir Statman)
While the focus of market manias changes – mining, biotech, Chinese stocks, housing, etc… – the outline of a speculative bubbles remains remarkably similar over the centuries. Today’s newsletter examines the latest research into speculative bubbles and looks at how we can apply that knowledge, with examples of the recent booms (bubbles?) in Chinese stocks and Biotech. This newsletter is much longer than usual letter, in part because the topic is both complex and important. Skip ahead to the end for the Chinese and Biotech conclusions. Speculative bubbles_2
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