Unpleasant Facts

The only way to solve problems is to be willing to think about them first

Who Predicts Well - Does it apply to financial markets?

What makes a good predictor is a very interesting subject to those involved in financial markets.  Tyler Cowen highlights an excerpt from a piece by Dan Gardner and Philip Tetlock:

"…what separated those with modest but significant predictive ability from the utterly hopeless was their style of thinking. Experts who had one big idea they were certain would reveal what was to come were handily beaten by those who used diverse information and analytical models, were comfortable with complexity and uncertainty and kept their confidence in check."

Having one big idea might be a dangerous thing for money managers, but it seemed to work for some people who shorted the housing market.  The way to reconcile these two facts could be that the people who made money shorting the housing market weren't applying their one big idea about the future downfall of America or the idea that easy money is going to destroy the economy, but instead were the type of people who came to their conclusions about the housing market after studying various metrics and utilizing different analytical models.

It should be noted that just because the experts who are supporting their one big idea might be worse predictors in general, they may not be wrong in the long run. Those who favor a long gold strategy tend to have one big idea: You can't trust fiat currency (particularly the fiat currency of the United States), as throughout history all fiat currency has approached zero.  They see every sign of inflation as a sign that gold should go up in value and every sign of deflation as a sign that gold should go up in value.  Even though they have the wrong cognitive approach, over the past 10 years they've been right far more often than they've been wrong.  If someone marginally familiar with Tetlock's research decided to sell gold because they didn't like the arguments of people buying gold they would have lost a lot money.

On bearish journalists and bullish asset managers

"Any intelligent commentator will over time feel more comfortable from the bear position, just as most traders trade from a bullish bias.  There are more negative things that can be said in an intelligent way. The hidden order of markets that generally make things work is not easily described by a journalist.  The only consistently intelligent bullish commentary I've read has been from Niederhoffer and McKinsey. There is more money to be made buying assets than selling them short.  However, that doesn't prevent dedicated short sellers from making money."

This is an excerpt from an email I sent to a friend over four years ago. It's still rings true today, even if asset managers with a bullish bias have not has positive returns in recent years. There is only so much money that can be allocated towards selling assets short. If it is ever the case that short funds seem almost as popular as long funds, it probably means that it is time to load up the truck and buy equities.

Links: Japan's tragedy and some of its implications

1. A lot of videos of the horrific damage from the tsunami are going around. This one shows how the wave wipes out villages (Warning: Graphic) as it approaches the shore, while this video shows just how destructive a large amount of water can be to a city even when it isn't moving at huge speeds.

2. Some people are wondering how Japan will be able to finance its reconstruction.  Peter Westaway of Nomura expects rating agencies will "cut Japan some slack" for humanitarian/public relations reasons. While this will reduce the need for some institutions with strict rules to keep their money out of Japan it also means that the market could move well before the ratings agencies do.

3.  The Bank of Japan is flooding the market with yen. Weighed against this move and the government's new fiscal position is the repatriation of Japanese household's foreign investments combined with expected insurance payments that will flow into the country. These inflows help explain why the yen hasn't moved very much and has actually slightly strengthened against the dollar despite the huge economic shock that has sent its stock market tumbling more than any other two day period since 1987.

4. There appears to be less looting in Japan than in other recent natural disasters. One politically incorrect explanation is that groups of people with high IQ's are more likely to cooperate in prisoner's dilemmas. (HT: Garrett Jones) 

5. The biggest impact of this tragedy on America's future might in how it seems to be scaring people away from nuclear power.  If the situation at Japan's power plants gets any worse the future of nuclear power in America will be very dim.

What a naive long China strategy misses

People who go long China's economic growth by buying their equity index will miss out on a lot China's growth. Via the Economist I came by this interesting fact:

"Qiao Liu and Alan Siu of the University of Hong Kong calculate that the average return on equity of unlisted private firms is fully ten percentage points higher than the modest 4% achieved by wholly or partly state-owned enterprises."

While looking at this, it is important to note that this is just state owned firms and not firms with ownership by government officials. But the outperformance of unlisted firms does suggest that the average investor looking to go long China's listed equities are not participating in a large portion of China's economic growth. Marc Faber anticipated this as far back as 2002 when he wrote Tomorrow's Gold and made the analogy between China today and the United States in the 1800's. The 19th century United States economy grew a lot, but the opportunities available to foreign investors, mostly railroad stocks, didn't give foreign investors corresponding returns.

The beginning of the end for low vol?

Eric Falkenstein wrote one of my favorite books on finance, Finding Alpha. In this book, he goes over the typical lifecycle of market inefficiencies. Markets might mis-price volatility or Eurodollars or under estimate stock market daily reversals for an extended time period, but once people find out about it and have the tools to easily trade it the alpha available to investors in the know decreases.  In the same book and on his blog he also promotes his pet investment thesis: low volatility stocks or avoiding high volatility stocks. If CAPM is wrong and people are basically envious rather than risk averse then their main goal is to outperform the benchmark. Low volatility stocks offer no hope of outperforming the benchmark and in fact consistently underperform it during bull markets. Because of this they are subsequently undervalued and massively outperform during market turbulence.  Their risk adjusted return across stock market cycles is better than the index as a whole by over a percent a year. This doesn't sound like much, but a one percent growth rate differential matters a lot over the long run.

Recently, Falkenblog has been pointing out all of the people coming around to this point of view. As someone who wants to take advantage of this strategy in scale this is worrisome (Even if the prospect of being able to choose to apply this strategy via ETFs is also convenient). It is starting to look like the strategy is going to get crowded. The low volatility strategy probably isn't crowded right now, but it looks like that this cycle might be the time that it finally becomes popular enough to impact returns. If that's true, than that means that this cycle will see low volatility stocks underperform to a much lower extent but also fail to outperform to the same extent during the next bear market.

It will be interesting to see how many low vol ETFs are introduced and their subsequent popularity.  Measuring the AUM of low vol ETFs and funds is a good way to track just how popular the idea is getting because mentions in press and conferences will only matter insofar as they are reflected by the choices investors are making in their portfolios.