Having a Computer Named Hal for A Money Manager: Why Mathematical Models Do Not Beat the Market Over Time.

Posted:
Friday, March 31, 2017

Investors are constantly looking for the equivalent of the philosopher’s stone. In the middle ages, such a stone was reputed to turn base metals (like lead) into gold. While many a chemist died from the fumes created from such experiments, no one thought to ask the question: if anyone had been successful in the endeavor, how far would it have brought down the value of gold by increasing the supply?  

In the current era, instead of alchemy, investors look for some mathematical model that will provide excessive and consistently positive returns. Universities and brokerage firms try to find “excess alpha” relative to “beta”. These are technical terms that supposedly ferret out higher returns relative to the risk taken. 

This is all part and parcel of treating the market as some sort of efficient mass that will remain constant long enough to bend to the will of the quantitative specialists who dedicate their lives to such endeavors. A lot of money is spent on the pursuit of such opportunities. Not a lot of result has come out of it.

In recent history, the first effort to attain returns with less risk was the portfolio insurance fad of the 1980s. By buying put options against a basket of securities, an investor was supposed to be able to offset or hedge the risk of the portfolio going down in value. 

However, on October 19, 1987, so many sell orders entered the market that the portfolios could not maintain their value. In the ensuing plunge, no one was willing to issue new options to underwrite additional losses. The stock market fell 23 percent in one day; the credibility of portfolio insurance was destroyed.

This contraction and others since show the key limitation of mathematical model investing: what looks good on paper may not always work in real life. This is due to the fact that unlike the physical sciences, the investing environment is constantly changing. If there is no one to accept your securities close to the last price quoted, the market no longer works and the mathematical model is discredited. Technically, such an environment is described as a “lack of liquidity”. More recent examples include the pricing of mortgages prior to and during the crash in 2008, and the flash crash of stock prices in 2010.

Many investors are retreating into index funds, considering them to be a more passive way to invest. Variations on index funds have been around previously, but the larger computer power of the present has made them more accessible to a greater number of people.

People tend to refer to index fund investing as “passive investing”; in reality, there is little that is passive about it. To demonstrate, consider an index fund made up of two stocks, A and B. The index holds equal amounts of both stocks. No new money will come into the fund.

In the course of one trading day, stock A doubles in price, but stock B declines. The computers at some point will dutifully buy more of A and sell part of the position in B to raise the funds to do so, as A now makes up more of the value of the index. 

From this example, it becomes obvious that the index fund is facilitating the escalation of the price of stock A and the relative decline of stock B. If this is warranted by events, it is one thing; if it is not, then the index fund has acted as a momentum facilitator, causing the price of A to rise and B to fall as an exaggeration of what is going on in the overall market itself.

Believers in efficient markets will say that this is how it should be, as the index simply reflects the performance of the underlying stocks. And so long as the index fund stays stable or grows, this is arguably correct. However, what happens when people begin to cash out of index funds? The same stocks are sold in the same relative amount compared to their performance. 

What the associated company does is of no account—the price dictates the direction. Thus, any loss of faith in index investing would exacerbate the movements in the associated stocks in the index.  What they represent and how much they pay in the form of dividends would count for nothing.

A derivative of index investing is the so called “robo investing”. In this case, a computer picks out your investments. Fees can be low, and decisions are backed by algorithms.

While this approach is more dynamic than indexing, the success is a function of the computer programming. It is also, over time, its downfall. As more investors sign on to the same program, at what point can the computer sell a security en masse without affecting the price?

There are some truisms in investing. Low price to value generates higher returns than high price to value. Dividends provide about 40 percent of a stock’s return, etc. The thing that frustrates investors is that these truisms largely work over time, but not all the time. Investor fads and fashions throw people off their intentions of being long-term investors, generating a lot of what is known in the trade as “rainbow chasing”, a term for people who buy into what did well last year. Turnover and changing strategies are the reasons why the average investor gets only a fraction of the market’s return. 

The Economy

Continuing advances in the number of people working has underpinned economic growth for the past year or more. Consumer confidence in the economy, both present and future, should lead to the rise in the purchase of bigger ticket items like houses, bigger cars, etc.

What is absent at this stage of the economic cycle is any commitment from most businesses to materially raise capital spending. Companies are taking a “wait and see” attitude towards increasing capacity, fearing overcapacity if the economy turns rather than fearing not being able to accommodate a higher level of sales.

One thing that might change mindsets would be the administration’s infrastructure spending project, with a discussed $1 trillion spending on road, bridge, airport, and other infrastructure projects over a ten year period. As a priority, this ranks behind tax and trade reform. Given its ability to extend the economic expansion, one hopes it is not deferred forever. 

Inflation

Inflation at this time is far more pronounced than data would suggest.  The combination of a smaller entering labor pool, large numbers of retiring workers, the virtual elimination of immigrants from the equation, and an overall expanding economy, have all conspired to put significant pressure on employers to find qualified employees.

The businesses hurting the most at this time are those with seasonal needs and who are not in a position to offer year-round employment. Increasing numbers of tomatoes are being imported from Mexican farmers as US growers cannot find pickers. It is hard to see who benefits in this scenario.

Interest Rates

After rates were raised once last year and once so far this year, debate centers on whether there will be two or more increases in 2017. This would total a short-term rate of about 1-1.25%.

Going into 2018, interest rate increases will probably continue, if not accelerate. Much will depend on the size of the Federal Deficit and the ensuing need for funds to finance the same. Talk of taking any government spending savings and applying them to lower taxes does nothing to shore up the finances of the United States.

The Stock Market

 

Stocks are trading at not only record levels, but close to record valuations. Typically, high valuations imply underperformance going forward for the next 3-5 years, until profits reduce valuations to a more normal level.

The most recent surge has been attributed to the administration’s promise of lower corporate taxes for businesses. If taxes are reduced for a business, all else being equal, after-tax profits go up. It is this expectation of higher corporate profits due to government fiat that has so influenced this rally.

The issue is: can the country afford such a corporate tax reduction for its potential ability to increase the deficit; and, if not, what happens to stock prices (at least in the short run) if the tax reduction does not come to pass? At some point, bonds are going to be competition for stocks in terms of the investor’s dollar, as they were almost continually until 2008.  Higher interest rates along with higher wage expenses will also adversely impact income statements. So long as money is cheap and available, there will always be those who will hold up the market by borrowing funds to do so. However, as Warren Buffett once said, “It takes a tide going out to see who is swimming naked.”

 

                        Warren M. Barnett, CFA

                        March 31, 2017

Warren Barnett, Founder & President, CFA - Barnett & Company

Warren Barnett

Warren Barnett is the founder and President, and Portfolio Manager for Barnett & Company. He was associated with the investment banking firm of Kidder, Peabody & Company and the investment counseling firm of Davidge & Company in Washington before returning to Chattanooga to accept a position in the trust department of a local bank. Perceiving the local need for the type of firms with which he was associated in Washington, he established Barnett & Company in 1983. He obtained the Chartered Financial Analyst professional designation from the Institute of Chartered Financial Analysts, Charlottesville, Virginia in 1986. Mr. Barnett graduated from The McCallie School in Chattanooga. He received his Bachelor of Science degree in Accounting from the University of Tennessee at Knoxville and his Master of Business Administration degree in Finance from the Owen School of Management at Vanderbilt University.

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