Don’t be Stubborn!

Near the top of investor mistakes is the stubborn adherence to something that has been proven wrong.  The error might be a strategy, an economic viewpoint, a market opinion, or the choice of favorite pundits.  You need to step back and reevaluate when there is important new information.

Here are two key examples:

  • The failure of Lehman.  Many thought that the big investment banks were too big to fail.  It turned out not to be true.  While some still think that the government should have acted, those in power felt they lacked authority to act.  In the aftermath we all learned what would happen to the economy if there was no confidence in any financial institution.  What we call "normal and sensible lending" came to an end.  Most mainstream economists adjusted their forecasts to account for the extreme reaction of corporate leaders.
  • Massive government intervention.  Many thought that the government would be powerless or ineffective.  This turned out not to be true.  While some still think that the government actions were wrong, those in power saw a responsibility to act very aggressively.  In the aftermath we all learned what would happen when there is aggressive action and intervention by the federal government.  Most mainstream economists adjusted their forecasts to account for the extreme reaction of government leaders.

Ironically, many observers who were accurate on one of these key points missed the other.  In a further touch of irony, economists who adjusted forecasts in both cases (notably those in the mainstream) are now frequently criticized for "missing" the first move.  The implication is that their current forecasts will be wrong.

The Three Doors Problem

We anticipated this situation in June when we asked the following question:

You get the chance to be on a game show.  The host lets you pick one of
three doors for a prize.  One door has a great prize and the others
have trivial rewards.  You make your pick.  The host (who knows where
the real prize is) reveals one of the two alternatives and offers you
the chance to switch your choice.  Should you do so?

Top traders with whom we have been associated use this question as a screening test for new recruits.  Getting it right on the first pass (easy for bridge players, who are experts at probability) is excellent.  Since most people fail on the first pass, the question is how long it takes them to accept the answer.  Some of the most intelligent people in our universe could not accept the solution.  That is a bad trait for a trader!

The Solution

The problem is a simple probability question, but the answer is counter-intuitive.  The best simple explanation comes from Leonard Mlodinow, whose book, The Drunkard's Walk,  we recently recommended.  The explanation comes from an excellent quiz presented by The Numbers Guy, Carl Bialik.

Answer: Yes. When you initially chose door No. 1, you had a one
in three chance of picking the car. The other scenario, in which the
car is behind one of the other two doors and so only one of those two
doors hides a cow, has a probability of two-thirds. Let’s focus on that
scenario, and assume — since we don’t have any information to the
contrary — that the host always opens a door that reveals a cow. In
that case, the door he didn’t open and that you didn’t choose always
contains the car. So if you switch, there’s a two-thirds chance that
you’ll win the car. If you don’t, you’re stuck with a one-third chance.

Bialik goes on to note the recent featuring of this problem in the poker movie, 21, which we recently saw on Netflix.  We might have chosen a different problem, since many readers now seem "clued in" to this specific answer while missing the concept.  Readers who want more such questions should look at his original quiz, especially #3, which has a similar theme (also a layup for bridge players).

The issue of stubbornness is highlighted in the reaction to Marilyn vos Savant, who presented the question in her popular Parade Magazine column.  Many "experts" disputed her answer.

Current Relevance

We see many economists and pundits who stubbornly adhere to a viewpoint that "called the crash" or had some method of market valuation that seemed, in retrospect, to be accurate.

Forecasts must change with facts and new data.  There is no substitute for keeping current on the best indicators.  We try to balance our fundamental analysis with market indicators from our disciplined trading system.  It is a reality check.  Many of the most popular financial websites have an ongoing commitment to finding the worst possible interpretation of any reported data.  There is a need for balance.

Data and Perceptions

Interpreting data requires special skill and training.  Hardly anyone has developed these skills, but that does not stop them from offering opinions.  Here at "A Dash" we have highlighted some of the most popular errors.  Today provided some examples.

This is America!  Let the games begin….

Public Opinion on Stimulus Plan?  Thumbs Down!

It is the six-month anniversary of the passage of the stimulus plan.  This was a classic political compromise.  Any and all observers could criticize the plan.  The symbolic language — shovel ready — conjured up the wrong image.  The announced plan suggested that there would be a lot of visible jobs from construction.  The actual plan relied upon macro-economic spending principles, and was scaled out over two years.

The unsurprising result is that the economy has still not recovered and most Americans believe the program is not working.  This includes plenty of intelligent people and Obama supporters.  To understand the impact, one needs to grasp the concept of the counterfactual (which we explained in easily understandable terms here) and the economic impact of policies like helping the states and extending unemployment benefits.

Anyone who understands economics knows that the stimulus has already mitigated a difficult situation.  It is to the political and personal advantage of many to attack the program.

Pundit Opinion on the Economy

Most of the punditry understands behavioral economics.  They know all about confirmation biases and the temptation to see each data point as support for a pre-conceived idea.

It makes no difference.

The market is looking hard for signs of economic growth, reacting to each twist and turn of the data.  Participants are missing the big lesson: What constitutes normal progress in an improving economy.

It is unrealistic to expect each economic indicator to show progress in lockstep.  The data will provide mixed signals — partly because of differences in sectors and partly through measurement errors.  If one chooses to look at the worst news or find the worst interpretation of data, one can be in denial for a long period of time.

It is all about finding the best indicators in an objective fashion.

What is Normal?

In our summer quiz, we highlighted a question about data interpretation which few understand.  We ran this article in June.  We expect that our quiz questions will eventually be recognized as the key market issues.

Here was Question #1.

We have an honest coin which we flip 20,000 times.  We keep a running
count of whether heads or tails is in the lead.  How many lead changes
would you expect?  (A good ballpark answer could be the winner here).

In his excellent book The Drunkard's Walk:  How Randomness Rules Our Lives, (now added to our recommended list) Leonard Mlodinow explains how people — smart people — fail to understand data because they do not understand probability.  His example involves a test of two movies, but the application is equally valid for many applications.  Two theories, two investment managers, two pundits…..

He writes as follows (page 14):

Because the coin has an equal chance of coming up either way, you might think that this is experimental box office war each film should be in the lead about half the time.  But the mathematics of randomness says otherwise:  the most probable number of changes in the lead is 0, and it is 88 times more probable that one of the two films will lead through all 20,000 customers than it is that, say, the lead continuously seesaws.  The lesson is not that there is no difference between films, but that some films will do better than others even if all the films are identical.

Mlodinow is a physicist who has written for popular entertainment like Star Trek and MacGyver.  He is excellent at making difficult concepts accessible to average intelligent readers.  He provides many other examples of normal random data, consistent with the work of the behavioral economists.

The key here is that a concept in the lead (the weak economy) will seem to retain the lead.

Our Take

We have attempted to highlight the important indicators. — ECRI, initial claims, and the ISM — and we will work to highlight others.  These important measures have been positive.  Many other measures that we follow — employment, Michigan sentiment — are giving a negative signal.

For stocks, it is all about earnings.  Bearish pundits dismiss the last round of earnings because the results were based upon cost-cutting rather than revenue growth.  (What would they have said if earnings had disappointed?)  We believe that revenue growth will soon follow with stimulus impact. Companies that have good cost control will show good earnings gains.

Meanwhile, those emphasizing trailing earnings can fixate on forced write downs from last year and the post-Lehman cessation of normal lending.  These pundits will miss the resumption of normal and sensible lending.  It is time to look ahead for opportunity.

Or one can fixate on last year.  Your choice.

Popular and Critical Acclaim

Over at The Big Picture Barry Ritholtz has some great suggestions about improving financial television.  We agree with the entire list, but especially like the following:

1. Stop Yelling. Stop interrupting. Stop Talking Over Each Other:  This is not Jerry Springer, its serious business. People’s retirement and investments are at stake. Please treat it that way.

5.  Lose the Octobox. Fire whoever came up with the Decabox.   ‘Nuff said.

6. Separate the Signal from the Noise
Understand that most of the day-to-day action is simply noise. Look at
a long term chart, you can barely see 9187 or 9/11. If those major
events get lost in the long term trend, what does the intraday jags,
kinks and reversals mean? Very little. Recognize that not every data
release, slice of news, or rumor is at all significant. Stop treating
them as if they were.

7.  Fact Check: An
awful lot of things on air get stated with authority and confidence.
Much of them are little more than junk or pop myths. Why is it that the
more dubious a proposition is, the greater the confidence the speaker
seems to muster? Consider fact checking as much of the statements that
are made on air as possible, and making frequent corrections.

9. Bring Back Louis Rukeyser: Not the man, but rather, his style. Wall $treet Week
— Rukeyser hosted it from 1970 to 2005 — was plain-spoken, thoughtful
and accessible. Quiet, contemplative, discussions, with intelligent
market participants, revealing helpful information. The investing
public would appreciate something of that sort — again.

Improvements Unlikely?

There is a reason for the current TV programming:  Ratings!

The experts know what sells.  Everyone on TV is asked to state an aggressive and controversial opinion.  It is entertainment.

Would the current investing world give a high rating to Uncle Lou, no matter what the quality of the program?

Popular versus Critical Acclaim

We recently watched an old film for which a reviewer had noted that it achieved both popular and critical acclaim.

That is certainly great news for a movie, and one can easily see the distinction.  At nearly any time one can find a very popular movie (the "date movie" from back in the day) that has little artistic merit.  At the same time, there is something playing at the local Art Theater that scores high on artistic merit, but does not attract many teenagers.

It is a delight when a film can satisfy both criteria.  It is also a great challenge.

The Investment Audience

Here are a couple of key facts about the audience for investment news:

  • Individual investors have dropped out.  (We'll get them back after another 25% or so in the major averages).
  • Most readers are obsessed with the negative.  That is how to seem smart at a cocktail party.
  • One can measure this with objective indicators, like our Seeking Alpha sentiment indicator.

The reader will note that we are moving beyond financial television, and considering all sorts of information.

The Conclusion?

With newspaper ad revenues disappearing, MSM are all turning to blogs.  Blog revenue is all about hit count.

If times were more prosperous, business managers could afford to think about the actual merits of analysis.  In times of stress, they look for the most popular.

So what happens?  We all know from behavioral finance that investors chase what worked most recently.   Today, that means that all of the doom-and-gloom predictors are geniuses.  Many of those writing and appearing on TV search relentlessly to find the most negative spin on any piece of information.

It is those people who are now featured.  It is not because of editorial bias on the merits.  It is financially driven.  These are the writers who are "popular."

This is what happens editors become pollsters.

How NOT to Think about Your Investments

Many stocks, perhaps most stocks, are trading at prices that do not reflect fundamental value, as determined by traditional methods.  The excellent team at Bespoke Investment Group, one of our featured sites, provides a great list of stocks trading at "crazy" P/E ratios.  (Since P/E is only part of the story, perhaps you should subscribe to their premium service.)  Unfortunately, we own a few stocks on that list.  Our cheap plays got even cheaper.

Bob Pisani's CNBC reports — a good reflection of floor trader opinion — pointed out the disjunction between the fundamentals and the price in stocks like IBM.  Great earnings, good prospects, no proximate link to subprime, but the stock is down 25% from the highs.

Briefly put, current prices are not a matter of analysis, but one of psychology.

It is time to check out our "go to guy" on such questions, Dr. Brett Steenbarger.

Great Advice from Dr. Brett

In any big event, whether it is a football game, the election, or the stock market, there is a nearly inevitable feeling that you "should have known."  He writes as follows:

When markets become unusually volatile, they make unusually large
moves. To the short-term trader or the active portfolio manager, such
moves look like phenomenal opportunity. This creates a kind of
dissonance when their results do not reflect such opportunity. This
dissonance is often expressed as regret: the word "should" becomes a
prominent part of traders' thinking.

Underneath this regret is
what behavioral finance researchers call "hindsight bias": the
exaggerated sense of predictability in retrospect.

After some typical wisdom, which deserves to be read completely, he concludes as follows:

Given the limits of what we know and what is ultimately unknowable, not
all movement is opportunity. The key to trading success is finding the
patience to capitalize on those things you do know and the wisdom to
accept what is uncertain.

Applying Brett's Advice

The most important step an investor can take is to understand what is happening.  Here is our analysis.

  • Our system has created a climate where banks will not lend with each other.  Why not?  After Lehman was allowed to fail, no one knows which financial institutions will get government support.  Why lend to an institution that might not deliver?
  • We are de-leveraging at Warp speed, since any write down at one institution ripples through the entire system as required by FAS 157 mark-to-market rules.
  • The lenders to hedge funds, all becoming regular banks, now have more conservative business models.  Leading fund manager Ken Heebner  made this point tonight on Kudlow.  See the video here and here.  The hedge funds can no longer take a strategy that makes 5 or 6 percent a year and leverage it five times.  This means that hedge funds are selling — forced selling — the good with the bad.
  • Individual investors are dumping their mutual funds, as they always do in times of stress.

What not to do

Do not just make a knee-jerk reaction.  Think clearly.  Think about what is happening and the causes.  That is the only way to spot opportunity.

Somewhere between Miss Moss's Latin class in high school and Neil Browne's excellent instruction in critical thinking, we learned about a prominent logical fallacy.  Once you know it you will see it every day.

Post hoc, ergo propter hoc.

You can look it up, but it means "after this, therefore because of this."  It is one of the most common errors in logic.

The most important application right now, also pointed out by Ken Heebner, is that the market keeps going down after each new government move.  The cause of this has nothing to do with government policy, except perhaps that it was too slow for rapidly changing conditions.  We should have started sooner, since government moves slowly.  It is the de-leveraging, especially in hedge funds.  To those who do not understand, it seems to be an instant verdict that the government plan does not work.

And this verdict is being rendered before the $700 billion has even been deployed…..We suspect that legislators who voted for the Rescue Plan feel somehow betrayed by the market.  It will take some time before the impact of the plan is felt.

And finally, what you should do

Understanding the factors behind the decline is important in finding opportunity.  If one accepts Ken Heebner's observation of reality, there is one set of conclusions.  If one believes that the market is correctly signaling the next Great Depression, there is another.  We shall revisit that dichotomy.  It depends on solving the problem of counter party risk, which we described last month.

Meanwhile, let us consider more great advice from Brett Steenbarger:

The ability to adapt to changing conditions and maintain the search for
opportunity amidst market panic is a great example of how times of
crisis can also be times of opportunity.

We will follow up with more about how we are positioning our clients to take advantage of current conditions.

The New York Times Attacks Richard Syron

When does a good story get in the way of informing readers? Editors of all major publications face this decision each day. A recurring topic at "A Dash" is how many bloggers play fast and loose with facts. The Internet gatekeepers push along the stories placing the burden on readers. No matter how intelligent the reader, no one is going to check facts, sources, and analytical techniques for various stories.

With print media in competition with blogs, the distinction is starting to fade. Cyberspace is full of unedited and often unchallenged text. It lasts forever.

Background: The New York Times Attack

Charles Duhigg studied history at Yale and got an MBA from Harvard on the way to becoming a reporter for The Los Angeles Times and then The New York Times. His feature article on Freddie Mac and Richard Syron attracted plenty of attention and comment today.

The main contention is that Syron got a memo in 2004 from his Chief Risk Officer, David A. Andrukonis, warning that the firm was financing questionable loans. The next year Mr. Andrukonis left "to become a teacher." Duhigg has plenty of anonymous sources who confirm that Syron had this information.

Since we accept the factual authority of The New York Times, we do not challenge that there was such a memo. We also do not doubt that sources were confirmed. This leaves room for plenty of other complaints.

Challenges from our Blogging Colleagues

The best job of analysis on this article came early in the day from Tanta at Calculated Risk, one of our featured sites. She was clearly on a mission. Among other points she noted the following:

  • The Times short-changed Syron's resume;
  • Too many anonymous sources;
  • No recognition that this was one memo of many; and
  • Faulty grasp of the role of the GSE's.

Nice work.

Matt Stichnoth, writing for, has some other good points. He draws our attention to the following:

  • There was a big change from 2004 to 2005. These problems were not so obvious in 2004, and might not even have applied to loans at that time.
  • Recognition of Congressional pressure for Fannie and Freddie to pursue social missions; and
  • Recognition that the worst crisis in history might not have been totally foreseen.

Both of these articles deserve to be read in their entirety, as well as the original article.

Our Take

There is a common statistical problem involved here. In any large organization there are many people warning about many things. Sometimes the warnings are completely unnoticed. Sometimes they are evaluated but found to be unpersuasive.

If one starts with all of the situations where there is "a warning" the executive might have done very well. Who knows how many problems Syron correctly anticipated and solved or how many bogus concerns that he ignored.

If one begins with the conclusion, it is usually easy to spot something. Finding the warnings that should have alerted someone to the big mistakes is a classic revisiting of history. Some examples include the following:

We are surprised that these incidents were apparently not covered sufficiently in the Yale history program, nor the statistical problem in the Harvard MBA program.

There is also the policy perspective. The reason that GSE's had implicit government support is that they were following national policy, using prescribed rules (including degree of leverage), and overseen by appropriate authorities. It was a balancing act.

Whether these organizations, neither fish nor fowl, are appropriate mechanisms of policy is a question for another day. Second-guessing the executives confronted with difficult decisions is another matter altogether.

The Consequence of Journalistic Choices

We doubt that most readers, on their own, thought about the many points raised here or by Tanta and Matt. Since The New York Times has a much larger circulation than the bloggers, only a few will be alerted.

Our guess is that most will accept this as just another case of corporate greed. For every issue there is some simple heuristic, a lowest common denominator if you will, that resonates with those who have conclusions in mind when they read news. We are disappointed, therefore at the conclusion reached by another of our favorite sources. After noting that Syron has received $38 million in compensation since 2003 while the stock prices have declined, here is the conclusion offered:

This was simply greed on the part of an executive, a transference of wealth from Shareholders to himself . . .

Full Disclosure

While we have no position in Freddie Mac (FRE), we have a recent and very successful position in Fannie Mae (FNM) — long stock and short the pumped August calls.

The Psychology of Risk

Each year millions of sports fans enter bracket pools for March Madness, the NCAA basketball championship.  Participants buy an entry or two for modest amounts like ten or twenty dollars.  Most who join in rarely, if ever, make even small wagers on specific sporting events.  March Madness  and the Super Bowl are different.

With tonight’s championship game we have an opportunity to use the bracket pool to gain a little insight on risk and how it affects behavior.  The situation described nearly always arises when the championship game is to be played.

A Typical Case

Let us suppose that a player enters a large bracket pool for $25.  Through a combination of a few astute guesses and a lot of luck, our hero is in line for a useful prize.  If Kansas wins, he will win about $1500.  If Memphis wins, he will win about $1200.  A celebration will be in order either way.

When asked his opinion about the game, our ace handicapper tells us that it is a coin flip.  Why did he make the choice he did?  It was a close call, with no real reason to favor Kansas over Memphis.  Asked if he would make a bet on either team, our hero says "No."

Hedging, Anyone?

Let us now suppose that a friendly neighbor happens to be a big Jayhawk fan.  He offers to bet $150 with the lucky pool prize-winner.  The effect of this bet would be that the expected victory will be $1350, regardless of the outcome of the game.  Should he accept the bet?

Our experience, observing scores of friends and pool participants in these situations, is that they stick with their original entry.  They may think that it is "unlucky" to hedge — a silly notion since they are locking in a set amount.  They may think that it does not matter, since they are in for a nice prize either way.

True enough.  The $300 difference may not seem like much when viewed in terms of the overall prize.  In a few days, however, when the contest has been forgotten, the result of the game will have a net effect of $300 in actual spendable money.  A week later, the winner will be making decisions about saving a few bucks in amounts much smaller than $300.  Even Doug Kass could fill up his Range Rover three times at the most expensive gas station in Palm Beach, Florida with the difference in prizes!

A Point of Comparison

By way of contrast,  let us suppose that our  pool  hero had failed to submit his entry on time.  Would he now be betting $150 on Kansas?


While the situation here is, of course, completely hypothetical (err–Go Jayhawks!!), the circumstances cited are quite real.  Some of the winning disparities are much larger.

A key difference between professionals and the individual investor is the ability to assess and limit risk and to realize that every result counts.

If you cannot pass this investment test, turn over the car keys

Here is a key question for investors and traders alike:  Do you want to be entertained by the colorful opinions of bloggers about what government should do or would you rather profit by understanding what they will do.


We have highlighted the distinction between normative and empirical analysis — opinions about what ought to be done versus the dispassionate study of behavior.  We suggested in December that the Fed was on a mission, using creative tactics.  We highlighted an excellent article from Abnormal Returns describing the difference between "Positive and Normative Blogospheres."  We have suggested that those offering opinions should first get some information — at least reading some Fed briefings and old transcripts of meetings.

A Good Explanation

While doing research for our sister site, Election Stocks, where we analyze candidate issues and link them to specific investments, we came across a five-year analysis of the Iraq war.  We recommend checking out our comment on this subject, and the complete study.

Meanwhile, the explanation of the work provides an excellent insight into the distinction between those doing "politics" and those doing public policy analysis.  The report comes from a private sector group.  They make money by providing analysis, not opinion.  The following is the explanation of their mission, taken from the report:

The debate is over whether the invasion was a mistake in the first
place, while the divisions over ongoing policy are much less real than

Stratfor tries not to get involved in this sort of debate. Our role
is to try to predict what nations and leaders will do, and to explain
their reasoning and the forces that impel them to behave as they do.
Many times, this analysis gets confused with advocacy. But our goal
actually is to try to understand what is happening, why it is happening
and what will happen next. We note the consensus. We neither approve
nor disapprove of it as a company. As individuals, we all have
opinions. Opinions are cheap and everyone gets to have one for free.
But we ask that our staff check them — along with their personal
ideologies — at the door. Our opinions focus not on what ought to
happen, but rather on what we think will happen — and here we are


The Stratfor description is exactly what makes public policy analysis valuable.  It is just what we are trying to do at "A Dash."  While we have opinions about what government should do, our mission is in helping investors understand past actions and predict future moves.

Those who do not understand this distinction are failing an investment Breathalyzer test.  They have become intoxicated with the  punditry and the debate over policy while losing focus on the cumulative effect of the many incremental policy changes.  These changes are starting to add up, (yet another future topic.)

Meanwhile, if you do not see the difference in these types of analysis, you should do the following:

Turn over your investment car keys to an index fund manager!

Investors Look at the Wrong Information! Why?

It is difficult to beat the market.  Individual investors who try to do so have, on average, results that are decidedly inferior.  And not just by a little.  It is more like half of the market return.  They try to time the market using all of the wrong methods.  They are afraid when they should be active.  They are "all-in" when they should be cautious.

We are developing some general themes — common mistakes — but our effort is one of building the case a step at a time.

An Example

Before departing on a long weekend of pure relaxation, we tried to leave investors with an insight that we felt was particularly valuable.  Our experience shows why getting perspective is important.

Earth to OldProf:  They do not get it! We posted an article on why accounting rules may be misleading investors.  We know that this is important for several reasons:

  1. It affects all of the financial stocks, an important key to the  market;
  2. General understanding of the issues is poor and reflected in the prices of many stocks:
  3. The financial write-downs get plenty of daily play, with each new story changing analyst estimates.
  4. The crucial element of understanding requires knowledge of accounting rules, the immediate effect, and the longer-term implications.
  5. The big mainstream media sources report each fact, but often do not provide an analytic framework.

With this in mind, we wrote about how the rules affected a key company, AIG, and the market impact.  Quite frankly, we hoped and expected that this would generate some interest and comment. Wrong! What were we thinking?

We checked this with our own small focus group and got a big yawn.  No one wants to think about FAS 157.  It is over the barrier of complexity.  If things get too technical, everyone tunes out, no matter how important the topic.

The focus group was correct.  We pay little attention to daily traffic at "A Dash" since we are not doing advertising, but we do periodic checks to see what resonates.  FAS 157 causes eyes to glaze over.  No one cares.

This myopia is empowering for those who take each issue to the lowest common denominator.  FAS 157 was a big story when the bearish bloggers saw last November 15th as a doomsday date like Y2K.  When it did not happen, the powerful writers in mainstream media did not point this out.  There is no accountability.  It is easy to make big predictions of write-downs.  And it is newsworthy, picked up by all of the popular media sources and financial television.


There is always a way to appeal to an audience without providing understanding.  Realizing this is the biggest challenge and the biggest opportunity for investors.

The credit market issues are difficult to understand.  Investors and traders are not really capable of making independent decisions.  Even if they work to get the facts, it also requires a solid analytical framework.

We shall pursue this with some other examples.  Meanwhile, we need to work on article titles!  Maybe if we had called the article DOW 15000 and included the Sports Illustrated swimsuit indicator, with a picture or two, it would have gotten more attention.

Understanding why FAS 157 is important is both more important and more challenging.

Another Round of Panic

Trading and investing are quite different things, a matter of time frames.

Today’s trading was sparked by the ISM services report, something that has not attracted much attention in recent years.  The Market has focused more on the traditional ISM manufacturing survey, partly because it has a longer history, and a clear link to GDP.  For those who have forgotten that report, released two trading days ago, it suggested GDP growth of 3% as of mid-January, the time of the survey.

The ISM service release was surrounded by some controversy because of a change in the method of calculation and the early release of the data.  The ISM, in circumstances nicely reported by Kelly Evans of the WSJ,  admitted in a conference call that information might have leaked, so they announced the result before the opening.  We are always amazed to see that people do not realize that big traders can always find a way to play information when regular stock markets are closed.  Globex futures trading, anyone?

Significance of the Report

Most market participants realize that the service economy has assumed greater importance in recent years.  The large move in the index played into the recession fears of many.  As the market declined, this seemed to be confirmation of increasing recession odds.

The market and media reaction was that if many react to a piece of data, it must be right.   Let us look a bit deeper into this information.  When so many stampede, there may be a contrarian opportunity.

We have tested the ISM service series against employment changes and other economic data, and we find it to be pretty good.  When comparing it to the ISM manufacturing index we discovered that it did not add much information.  We now have a single data point where there is a significant divergence.  This would be nice to test, but there are not many other divergences to use.

Our review of today’s news did not find anyone else who highlighted this statistical fact, or wondered about the meaning.  This provides an edge for our readers.

Other Interpretations and Advice

We realize that those with a predisposition to seize upon any evidence of incipient recession are touting today’s number, even if they never mentioned it before.  Readers might want to compare the current interpretations from these sources with those from past months when the services figure was stronger than manufacturing.  There is a lot of selective perception at work.  Pick your favorite source and do a search to find out whether this number was ever highlighted when it was strong., an unbiased interpreter of information, reports as follows:

The data seem inconsistent with the harder figures on spending and investment
and world trade which really provide the trends for domestic growth.  We also
believe that the intent of this ISM index — to reflect on growth for the entire
economy outside of manufacturing — is a mighty grand objective given the
simplicity of the survey questions. 

For each component (e.g.  activity, employment, orders), the question to the
survey respondents is simply, "Are conditions stronger, unchanged or weaker than
the prior month?"

Gary D. Smith, who has a strong multi-year record of market forecasting, provides excellent daily commentary on his blog.  Unlike some other providers of links,  Gary cites information from every possible source.  He tells the "whole truth" without any cherry-picking of information.  Here is his take:

I continue to see the US Fed as now “ahead of the curve” and the odds of an intermeeting rate cut are rising meaningfully. The VIX is rising 8.0% today to a high 28.0. The ISE Sentiment Index hit a below average 102.0 and the total put/call is hitting an above average 1.12. Finally, the NYSE Arms has been running very high again all day at 2.47, which is also a positive. I
still view the odds of a full retest or new lows in the market as
unlikely and further weakness providing good entry points in favorite
longs for investors.

Read the entire article to get the full context.

The Earnings Mythology

The recession hypothesis is getting an additional boost from commentators who claim that forward earnings are in decline. has some great information on this:

According to Thomson Financial, fourth quarter 2007 earnings are expected to
decline by 20.7%.  The main reason for the decline is the financial sector’s
whopping 105% decrease in earnings.  If the sector was removed, earnings would
grow by 11.0%.  Homebuilders are also a drag.  For example, the consumer
discretionary sector’s earnings would grow by 7%, instead of declining by 15%,
if homebuilders were removed from the calculation.

In general, we do not like throwing out the worst or best sectors from the overall S&P 500 earnings.  This might be an exception.  The last quarter is a bit unusual because of the forced write downs of mortgage securities.  Some believe that there are many more write downs to come.  We think that the FAS 157 losses might actually overstate the impact on these firms.  They voluntarily chose to keep securities on the balance sheet, probably because the expected performance to exceed current value in an illiquid market.  The jury is out on that question.

Meanwhile, the rest of the market sectors are not showing mean reversion, recession, or any other sort of earnings decline.  For example, Colin Barr’s nice review of the Disney report highlights a good past quarter, and good future prospects.  This is a company that one would expect to be hit by consumer distress, if it were already an important factor.

Forward earnings will depend greatly upon how financial stocks rebound from current conditions.


Markets look forward.  Even in recessionary times, a fact not yet in evidence, forward earnings look through the recession, setting the stage for rebounds in stocks prices.

Three Business Decisions

One of the valuable things for us in writing a blog about a book, what we are doing at "A Dash",  is that we can see what is working and what is not.  By "working" we mean helping readers to understand something important that will be profitable in their investing.  This is not strictly a function of popularity of the article.  Reader comments are especially valuable.

It is a bit tricky, because the current audience in the investment blogosphere is much different from the one we will see in a year or so, when many new investors will turn to the Internet.  We are writing to the future readers, the audience for the book, where we will review many of the current blogs.  By contrast, the current roster of most popular blogs is aimed at the present.

Our purpose here is to illustrate something important, a concept which would have helped individual investors and traders alike last week.  To do so, we must find a different starting point.  So let us talk about three real public companies and important decisions they made.  All three companies are big names that you know.

Company A

The first company was engaged in a market share battle with a competitor.  Within the company came an idea for a new product that moved closer to the competitor’s product in characteristics.  The idea was to skew toward a younger demographic and win market share.

Company A conducted field studies in the heartland, went through internal debate, and did extensive planning.  It worked up an advertising campaign.  With much fanfare, the product launch took place.

Company B

Company B was also fighting for market share.  Company B stimulates ideas from within, launching many of them as "beta tests."  Some work, some do not.  Those that work get further development.  Those that do not are dropped.  There is some internal planning and decision making, of course, but the hurdle for trying something is relatively lower.

Company C

Company C is in a business with some domestic competition and a lot of foreign competition.  The established business is threatened by changing circumstances, so it is in a struggle to maintain market share, revenues, and profits.

Company C was presented with an idea that might provide an immediate boost to sales.  The company did not know, of course,  whether the idea would work.  Since the idea came from outside the company, it was subjected to many meetings and reviews, including representatives from many different departments.  At each meeting, questions were raised from a variety of perspectives.  The company considered both the merits of the idea and whether it needed to use the outside source.

When the idea reached the key decision maker, it was presented not by those who proposed it, but by an internal manager who listened to the meetings and conveyed the ideas.

Reader Challenge

We could have chosen many cases for each of the three examples.  Readers are invited to nominate situations that they think might fit.  While we will reveal specific examples, there is no single right answer.

Here is the key questions:

Which method do you think works best?  Which approach is used by the most successful corporations?

Which method do you think best describes the behavior of major corporations?

Following Up

We shall return to this topic to show the relevance to current stock market issues.  The key idea is that understanding organizational behavior is important to successful investing.