Stock Exchange: Model Picks Teach Us to Manage Risk

Individual investors are intensely focused on the concept of risk. And why shouldn’t they be? Finding an appropriate level of downside risk is paramount. However, too few give equal weight to the potential upside risk in their decisions. Permabears and doom-and-gloomers often watch from the sidelines as the market rallies beyond the fear of the day.

We’ve been able to enjoy such a rally in the wake of the election. As the uncertainty surrounding future government policy dissipates, investors have a broad range of new opportunities.This week, our models’ picks give us an opportunity to explore both upside and downside risk.

To help us cut through the fog, we are joined by Blue Harbinger (AKA Mark Hines).

What level of risk is right for you?

The Stock Exchange provides an expert-level debate on technical and fundamental analysis. (Important background is available here). Comments, dissent, and specific stock questions are welcome!

This Week—Is Athena late to the party?

It’s an extremely common mistake for investors to chase a stock on a rally, then panic and sell at the first downturn. This buy-high, sell low strategy is an obvious loser. Athena is our answer to everyone who wants to find a trend, enjoy the ride, and hop out near the peak. Let’s see what she has on tap this week.

Athena

Athena: Drill, baby, drill! Continental Resources, Inc. (CLR) was on a roll in November – though I couldn’t say why. All I see is solid upward trend and a spike in price to cap it off.

clr_technical_chart-athena

Blue Harbinger: Continental has some competitive advantages and challenges relative to other energy exploration companies, but its price still remains highly correlated with the price of oil. For example, Continental has competitive WTI break even prices of around only $30-$35 per WTI barrel, and it was an early mover in the Bakken Shale (Williston Basin). However, it will take a long time to develop its huge acreage.

A: I hadn’t factored in time for future development, but to me that sounds like potential for future growth.

BH: Two other things I know you didn’t factor in – the incoming administration (of which you have no knowledge), and attempts by OPEC to reduce crude supply.

Regarding the incoming Administration, it seems the regulatory balance may shift slightly towards pro-business, pro-profits and pro-growth, instead of pro-environment. That may work in Continental’s favor, but the bigger factor remains oil supply/demand, something the Administration has very little control of.

Regarding the attempt of OPEC to reduce supply, would-be buyers may have already missed that boat. Oil shot up on Wednesday (11/30) as OPEC agreed to its first oil production limits in eight years. Oil, as measured by US Oil Fund (USO) was up 8.65% on Wednesday, and Continental was up 22.88%. Caution is prudent with regards to initiating any new positions, because Continental will likely be very volatile in the near-term.

A: Well that’s all very interesting, but I’m only looking to CLR for the next couple weeks. Am I wrong to see upside here?

BH: We certainly won’t see any concrete policy shifts in your time frame, but that may not matter. Sometimes the appearance of a shift to market-friendliness can move a stock just as much.

Felix

I’m not looking for anything nearly as risky as Athena. Looking out a year or two down the road, I expect broad-based gains from the biotech sector (IBB).

ibb_technical_chart-felix

We’re reaching the bottom of a year-long slip, and the market seems to be correcting its perception of what IBB has to offer.

BH: From a contrarian standpoint, biotechnology and pharmaceutical stocks are attractive. And ETF IBB is a decent way to play the space because it provides diversified exposure at a decent price (the expense ratio is 0.47%).

F: Who’s the contrarian here? It looks like the market is coming to terms with a drastic change in this sector. Could the recent election be having an impact here too?

BH: It makes sense to consider IBB with regards to the goals of the incoming Administration and Congress. Hillary Clinton caused several big drops in IBB over the last year simply by taking issue with the way drugs are priced. Now that her Presidency seems off the table (at least for the next four years), and the threat of the House and Senate being flipped has been removed, the prospects for biotechnology and drug-makers looks better. IBB did pop (up nearly 10%) the day after the election, but it has given back nearly half of those gains.

If you are a long-term contrarian investor, it may make sense to consider some of the individual stocks within the ETF because you don’t have to pay the 0.47% annual expense ratio. For example, the two largest holdings (Celgene and Biogen) have only underperformed the broader market (as measured by the S&P 500) slightly over the last year. However, the third largest holding, Gilead, has dramatically underperformed. We don’t own Gilead, but we wrote about its attractiveness at the end of May (Gilead: A Trump Stock Worth Considering), and it’s valuation has only become more attractive since then.

Oscar

Fantasy football is going to be the death of me. I liked OBJ a few weeks back, but I didn’t like the Giants next few matchups. I left him on the bench. Naturally, he started playing his best games of the season. This on-again-off again approach isn’t working for me.

BH: Did you want to talk about stocks here or what?

O: Right – you gotta stick with what you know. I’m back on airlines & airline manufacturers. I liked ’em near the end of October and I like ’em again now. Check out BA. This one looks like a winner through the end of December, at the least.

 

ba_technical_chart-oscar

BH: Industrials in general (as measured by the Industrials ETF, XLI) have performed well since the election, and Boeing has performed well too. Industrials (like Boeing) tend to be cyclical, and the market seems to like the incoming administration’s pro-growth message.

From a valuation standpoint, Boeing is not unreasonable considering its price-to-earnings ratio (both twelve-trailing-months and forward) is within its historical range.

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O: Glad to see we agree (for once). Any reason to hold onto this one for a while longer?

BH: Boeing continues to spit off a lot of free cash flow that it has been using to reward shareholders with big share repurchases and healthy dividend payments. The dividend yield sits 2.9%, which is above average compared to the S&P 500, and may be attractive to many income-focused investors, especially considering interest rates are low and rising (i.e. bonds don’t offer a lot of yield and their prices will decline as interest rates go up).

Holmes

I spy brighter days for Under Armour (UA). The recent selloff here was overdone, and some recovery is expected. Since I’m familiar with profit-taking techniques like trailing stops, some recovery is all I need.

ua_technical_chart-holmes

BH: It appears the selloff was the result of management tempering long-term growth expectations. Under Armour has been growing like wild fire since 1996, but it’s a big company now, and it’s much harder for Under Armour to keep growing at the same high rate.

H: There may be some long-term concerns, but I’m not terribly concerned with that. How does this position look in the fundamentals?

BH: From a valuation standpoint, Under Armour is cheaper than it was, but it’s still very expensive, and the market still has very high expectations for future growth. For example, check out Under Armour compared to its rival, Nike.

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Blue Harbinger: The market can be very fickle when it comes to brands and fashion. Under Armour enjoys a lot of brand recognition and favorability now, but that can change quickly. Plus, it already doesn’t enjoy the same profit margins as Nike.

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H: Be that as it may, I’ll again say I’m really only interested in the stock’s modest recovery. Talk to me again in February, and we’ll see how this one worked out.

Background on the Stock Exchange

Each week Felix and Oscar host a poker game for some of their friends. Since they are all traders they love to discuss their best current ideas before the game starts. They like to call this their “Stock Exchange.” (Check it out for more background). Their methods are excellent, as you know if you have been following the series. Since the time frames and risk profiles differ, so do the stock ideas. You get to be a fly on the wall from my report. I am the only human present, and the only one using any fundamental analysis.

The result? Several expert ideas each week from traders, and a brief comment on the fundamentals from the human investor. The models are named to make it easy to remember their trading personalities. Each week features a different expert or stock.

Questions

If you want an opinion about a specific stock or sector, even those we did not mention, just ask! Put questions in the comments. Address them to a specific expert if you wish. Each has a specialty. Who is your favorite? (You can choose me, although my feelings will not be hurt very much if you prefer one of the models).

Conclusion

Our models’ picks for this week were uncharacteristically risky – but that’s not all they had in common. By and large, the gang picked big potential movers for their short-term potential. Fundamental analysis and broader market context raise questions, where technical pings see a big upside.

This is why it is important to consider your level of risk tolerance as a function of your objectives. For many long-term investors, these positions would have little to offer. For those with a trading mindset, there may be a tidy profit to make before the holidays.

What is Your Confirmation Bias Quotient?

Most thoughtful investors know and understand the concept of confirmation bias. Very briefly put, we selectively perceive and choose evidence that supports our existing beliefs. It is a powerful natural process. Everyone is susceptible.

 

Morgan Housel has a good challenge: “What’s something you strongly believe that’s likely wrong?” He has a wonderful description of the key problem:

 

And while most of us are OK being told we don’t know everything, being told we have a lazy thought process is hard to interpret as anything but an insult.

So we have the ultimate cognitive dissonance: Fully aware that we’re wrong about something but unable to admit being wrong about anything.

 

Unfortunately for the decision maker, fixing the process is the key to better results. There are various discussions about how to avoid confirmation bias, but they are pretty general and not well-linked to investment decisions. Even worse, many investment discussions descend into an argument about who is biased, instead of an intelligent discussion of the facts.

 

Since it is not easy to detect your own biases, I have devised a Confirmation Bias Quotient to help. I have scaled the test so that high is good.

 

  1. Anecdotes. If you pay a lot of attention to specific stories and examples, give yourself -3. Illustrations can add color to conclusions, but when used as the basic level of analysis if is too easy to find supporting narratives.
  2. Specific examples. Similar to #1 but probably even more common. How do you interpret information during earnings season? If you pay a lot of attention to news reports on specific companies, give yourself -3. (It does not matter whether the stories are positive or negative; -3 either way).
  3. Symbols. If you find yourself drawn to colorful or graphic symbols of events – new paradigm, stall speed, stagnation, or anything similar pointing in any political direction – give yourself -2. If you completely reject analysis of data, take an additional -2.
  4. Demonstrably biased data. Examples are things like ShadowStats, where there has been compelling and responsible refutation, without response, on several occasions. Or like the idea that over 90 million people in the U.S. are without work. There is a legitimate debate about some data, but a general rejection of this type indicates a preference for conclusions before evidence. Take -2 if you find these arguments credible.
  5. Emphasizing unimportant data. Choosing to use data rather than stories is a good step. The problem is that there are so many indicators, and most of them have little significance. If you are looking at the Markit PMI (for Europe, China, or the U.S.), or regional diffusion indexes like Empire or Dallas, give yourself -1. There are so many of these that you can find anything you want, and none of them are established as really important.
  6. Embracing biased interpretations. This happens so frequently that I can only give examples. Suppose that a source complains about seasonal adjustments one month, but not another. Or emphasizes sentiment measures only when pointing in the preferred direction. Or emphasizes some specific factor (birth/death adjustment, core measure versus headline) only when it fits their message. It is pretty easy to spot such sources if you look for them. If you find yourself in this camp, take another -1.
  7. Relying upon biased or weak sources. Mr. Buffett said that you should not ask your barber if you need a haircut. Why ask a bond guy about stocks? Or an emerging market manager about bonds? Or a hedge fund manager, who is not really there to help you, about anything? If you do not have a high level of skepticism about sources, take another -1.

 

If you are really mired in bias, you could have a score of negative 15 at this point. Let us turn to the positive factors. Each is worth a possible +5 points, for a total of +20.

 

  1. A willingness to separate your evaluation of the economy and investments from your personal political beliefs.
  2. Finding the most important economic indicators and sticking with them, even when they convey a message that feels wrong to you.
  3. Discovering sources that have demonstrated expertise and track records in the relevant subject.
  4. Being willing to read carefully the analysis of experts with differing viewpoints.

 

The Test is one of Process, not Conclusions

 

A crucial point: You may well reach a consistent bearish or bullish conclusion without significant confirmation bias. The test is about your information, method, and process — not about conclusions. Different experts can look at the same data and reach different conclusions. In my weekly WTWA column I carefully follow all four of the positive factors listed, and strive to maintain a high CB quotient. It happens that my conclusions have been correctly bullish. Some erroneously believe that this reflects bias. Not so. If the evidence changes, so will my conclusions. Why shift from a winning method for “cosmetic” reasons?

 

Scoring the Test

 

If your score is negative, your biases are costing you money. My estimate is that 70% of investors would have a negative score on this test.

If you have even a small positive score you are actively seeking objectivity – probably in the top 20% of all investors.

If your score is above +10, you are doing a very good job of seeking evidence. Your investment results probably reflect this!

 

Expensive Misconceptions

The investment world abounds with research reports.  Intelligent and educated people generally benefit from careful study and accrued knowledge.

While it seems unfair, the investment world is different.  A little knowledge can be a dangerous thing!

There are many examples of this.  I have been stalled on this important topic because I was trying to do a comprehensive analysis.  It is often better to just get started!  I will start  with some of the most egregious and costly temptations for consumers of financial information.  I welcome more nominations to the list.  This is a great topic for us all to share ideas.

Shifting Indicators

This happens when the “rules” for interpreting data change to fit the per-conceived conclusion.  One recent example by bears related to the divergence of small cap stocks.  When the Russell 2K stocks were leading, the market was “frothy.”  When they lagged, it was a warning divergence.

Other indicators like sentiment, the Baltic Dry Index, Hindenburg omens, etc. are cited only when they fit.

Bullish analysts do the same.  If the monthly report does not fit the story, just look at non-seasonally adjusted data. year-over-year, or something else.  Many reports are susceptible to various spins.  The only solution for this is to know the agenda of the source.  This is rarely provided.

A persuasive chart

Please consider this chart, which is offered weekly as evidence that long-term investors have little to gain in the next decade while facing a lot of risk.

wmc160418b

I have a simple question for you:  Could you step up in front of a group of people and explain this chart?  If not, why do you believe it?  A smart and influential guy presents something that you cannot really evaluate.  Why is this a sound basis for your decisions?

It is unchallenged because of the lack of peer review in the investment world.  It is challenging to explain the errors, partly because so few could appreciate the arguments.

A plausible story

So many investment arguments depend upon simple analogies that are immediately convincing.  The frog in the pot story (even though it is not true) is one example.  These are stories that enable us to imagine an outcome without any real data.

  • Stall speed for the economy.  Graphic but wrong.  Economic expansions generally do not stall out, despite the intuitive appeal.
  • The aged bull market.  This is another argument that appeals to intuition but has no supporting evidence.  Whenever there is a streak that exceeds normal history — a hitter in baseball, a basketball team winning many games in a row — there is a temptation to say that this must be ending soon.  In fact, a winning team or player is actually just as likely to continue the streak.  Bull markets and economic cycles that have longer-than-average length are no more likely to end soon. (Nice survival analysis from SF Fed).

Your intuition and the confident-sounding talking heads are both wrong.  It is plausible spin.  You can take a profitable contrarian position by betting on further economic recovery.

The insightful investor fights spin with data and analysis.