The Most Expensive Investment Research of 2006

I had an interesting call this weekend from my most astute investor.  Since he wants to be anonymous, let’s call him "Bob".  Here is our conversation, with a few pointers and charts included — items that he requested I send him by email.  [Readers will benefit from taking the time to follow the links to past posts.]

Bob:  I enjoyed reading your research reviews last year, and I have a question.  What was the most expensive Wall Street research for 2006?

Jeff:  Do you mean the report that had the highest price tag?

Bob:  (chuckling) No!  I mean the one that cost people the most money.

Jeff:  Ahh.  Good question and the answer is easy.  The research on what happens when the Fed is trying to achieve what people call a "soft landing."

Bob:  That would not have been my guess.  I was thinking the election cycle or something.  What was so bad about the Fed and the soft landing.

Jeff:  It was a perfect storm for harming the individual investor and average trader.  First, the original work was a poor research design, but subtle enough that it took some skill to see the problem.  Second, it came from a big name firm so it got a major play in the media – basically accepted as gospel on CNBC.  Third, the concept was elusive, and subject to misinterpretation.  Finally, the leading blog sites gave it a big play.  The result was that anyone listening missed a big rally.

B:  You sound like a professor.  But I asked the question, so what was wrong with the research.

J:  Lack of data is the main problem.  There have not been enough Fed tightening cycles to draw sound conclusions.  You have to reach too far into the past, and then you still do not have enough cases.  The researchers used all of the data they had without regard for relevance.

A technique used in Research Design 101 is to look at a time series of results.  The reported research results assumed that the Fed is no better now than it was in the Hoover Administration.  This is typical of Wall Street.  Fund managers all figure that they are smarter and better.  In any other field of study we expect that there has been great progress – nuclear power, space exploration, biotech, DNA matching, weapons development, better airplanes and cars – you name it.  Despite this, the Street thinks that decades of Nobel Prize winning research in economics and the development of computer modeling make no difference.  Criticizing the Fed is a game, like second-guessing football coaches.

Take a look at some real data on recessions.  A good question is what proportion of the time the economy has been growing versus in recession.  This chart shows that by decade.
Recessions_by_decade It is readily apparent that the economy is now more resilient.  But the chart does not tell the whole story.

Fed tightening cycles have also had less impact on stocks.  Recessions — whether or not they result from tightening cycles — have had little impact on the overall earnings prospects of the market, as measured by earnings expectations for the S&P 500.
Recessions, when they occur, are briefer and with a smaller impact.  This is the best way to look at the data — as a continuous process of economic performance.  It reflects many factors, not just the Fed.

Even if one looks at the data from the perspective of a discrete series of Fed moves — the wrong method in my view — the stock market effect is quite different from that suggested in the original research.

After_the_fed_3If one  looks at "recent" data — say from the last thirty years or so — the  result is much different  from the conclusion drawn from the  "dead ball"  era used in the original research.  If you are trying to forecast, would you think that thirty years was far enough back to go?  In running your business, would you look at the recent trend or go back to the 20’s or the 50’s?

B:  I remember hearing and reading about this repeatedly.  Everyone said a soft landing was nearly impossible.

J:  That’s right.  We pointed out these problems in mid-August, but the media was running with the story.  CNBC quoted the study repeatedly.  Major writers featured it.  The big-time bearish blogs called it a myth.  They utilized pejorative symbolism which frightened the individual investors.  I warned about this out on "A Dash" and also in individual conversations.

B:  So those who listened to the mainstream media and the blogs lost out?

J:  Big time.  Those who did not understand this Fed cycle  have missed a big rally.  Even if there finally is a correction or recession, stocks may not dip back to the August levels.  Look at the chart.
[click to enlarge]Sp_500_6_months
Investors have missed 15% in the S&P 500 and 20% in the Nasdaq while waiting for a Fed-induced correction.  (Meanwhile, Vince’s intermediate-term models gave us a buy signal on August 8th.)

Even if we eventually have a correction or a recession, the pullback may not take us down to the August levels.

B: What do you mean about "understanding this Fed cycle."  You are not suggesting that this time is different are you?  We all know that is a mistake.

J:  When the tightening starts from a level that is far below "neutral" and proceeds very gradually to a point that is slightly above neutral, it is different.  It is not like a tightening cycle where inflation was already out of control, and the Fed needed to choke the economy.  I repeat that there are not enough cases for a quantitative analysis of tightening.

B:  Personally, I have followed your advice and remained invested.  Some of my friends have not.  What would you tell them?

J:  I am not surprised that many have missed out.  The misinformation on this subject reached many — perhaps millions of investors, while "A Dash" has a loyal readership best measured in hundreds.  That is actually a good thing for those who are just now getting involved. Most still do not understand, and we will see some fund managers chasing for performance.

Despite the rally, I feel that most of the opportunity remains.  Stocks have only begun to catch up with the record run of earnings growth.  I have tried to illustrate that in my valuation stories on "A Dash".

B:  I have been reading that earnings are going down, reverting to the mean.

J:  That just means that we are returning to normal growth instead of exceptional growth.  Don’t confuse a lower rate of growth with an actual earnings decline.  Take another look at the chart of forward earnings.

Meanwhile, I’ll try to cover the subject of misleading articles on earnings.  The list of topics grows….It is more difficult when writing fresh analysis.

And our conversation reverted to the normal subjects — sports, bridge, poker, kids, and good restaurants.  It is nice to have some astute investors who ask good questions.

Build your own trading system? Hmm…

Not so long ago, designing a trading system was viewed as a highly technical problem that required talented developers, special background, and great skill.  An individual investor would no sooner build a trading system than he would a refrigerator.

Advertisements for brokerage firms signal that this has all changed.  Several of the leading discount brokers now bombard television watchers with the same message:  You CAN do this at home.  One firm explains how easy it is to develop and back test strategies with their online software.  Another uses rotoscoped images to capture the indignation of some investors who are all smarter than their brokers.  A third shows investors making smart moves while taking a minute away from running the restaurant or the construction site.

At "A Dash" we have tried to show the challenges in developing systems and interpreting data.  Making powerful software simple to use and data more readily available just makes it easier for non-experts to lose a lot of money.

One graphic example is better than many admonitions from us.  Check out the story of a rookie prop trader and his foreign exchange system, as reported by Tyro.  Tyro’s friend was intelligent and methodical.  He did a lot more work than most and took what he believed to be a cautious approach.  After a month of awakening at 5 AM to test his system through paper trading, he was ready for the real show, going carefully with 2% positions.  You can guess the result.

He did many things right, but it is so easy to go wrong.  Go to Tyro’s site and read the entire well-told tale.  Thanks also to Trader Mike for highlighting  story.

Aspiring system traders should read (at least) Fooled by Randomness and the Portfolio Management Forumulas, the first book in the Ralph Vince "trilogy" (both featured on our recommended list at the right).  These books will explain many of the traps as well as some good methods for testing a system.

If you do not find these books to be real page-turners, (we did), then system trading is probably not for you.

Enhancing Trader Performance by Brett N. Steenbarger

At "A Dash" we have been reading Dr. Brett Steenbarger’s recent book, Enhancing Trader Performance, now featured on our recommended list.  (Some time spent in air travel is always good for serious reading.)  Our audience will find this book quite helpful.  In general, we feature work as we specifically cite it in our own analysis.  There are so many applications in this book, that we will be pointing to it repeatedly.

For now, let us consider a very general review, showing who will find the book helpful and why.

Greatest Strengths

The greatest strength of this work is the authoritative combination of theory and practice.  Dr. Brett draws upon a body of theoretical literature showing a logical progression from building competence, moving from competence to expertise, and using that expertise to become successful.  It is the whole package presented by a great writer who understands the theory.

Unlike many works where the strictly academic approach renders them inaccessible to most readers, this book is fun.  Each theoretical step is salted with examples from those who have achieved great success by implementing the principles.  The reader learns about how noted athletic performers like Dan Gable, Wayne Gretzky, Muhammad Ali, and Lance Armstrong employed the specific methods described.  This does not mean, of course, that these athletes had all read the relevant literature.  Instead, they learned or developed key methods on their own.  Nonetheless, their success demonstrates the power of the theories.

For traders, another great strength of the book is the application of theory to practice.  Because of his personal work in observing and helping traders with their problems and methods, Brett’s writing really comes to life.   Anyone has done some trading will recognize the characters in themselves or someone they know.  Any trader has experienced many of the same foibles as the featured characters, who are all real traders. The reality of the examples gives the lessons
and advice the ring of authenticity.

Wider Applications

While the book is aimed at a trading audience, it is quite useful for anyone engaged in competitive activity where performance is measured.  This is not just about trading.  Those competing in athletics or games of the mind will find the work most helpful.  Our own experience involves competing and coaching people in competitive activities like bridge, backgammon, chess, sports handicapping, poker, and debate.  Nearly every chapter has lessons for those striving for success in these fields.

An Important Lesson

There are also important lessons for the individual investor.  So much of today’s marketing makes it seem easy for anyone to beat the market.  Enhancing Trader Performance shows that learning the key lessons to become successful is hard work.  It requires a level of commitment that many would not have.  It is better to know this before starting, than to learn the hard way.


Briefly put, this is a must-read for traders and for system developers.  It is also recommended for those engaged in any competitive activity.  Finally, it is useful for individual investors.  Taking the time to understand the problems faced by top traders is the first step.  Those unwilling to make the time commitment to read and learn are unlikely  to achieve long-run success.  Read this book first!

Real Estate Sucker Bet

The major problem facing investment advisors is helping clients with
asset allocation.  Your client is intelligent and engaged.  The problem
is that they are focused on what worked last year, and your job is to
help them with what will work next year.

Our company has an internal ranking of pundits and advisors.  John Rutledge is one of our good sources.

Link:  Real Estate Sucker Bet

I was on CNBC’s Closing Bell with fellow guest and old friend Brian
Westbury to discuss the housing market on Monday, July 5. Brian and I
have known each other since the Reagan White House. He’s a great guy
and first class economist–one of the most …

I’ll expand on the housing theme in future posts, but we believe Dr.
Rutledge has it right on one of the major questions.  People have the
idea that real estate cannot decline in value — a dangerous notion.