This time it really was different

A couple of weeks ago I was driving around town through a familiar intersection.  Having lived in for fifteen years in  Naperville, a kid-friendly Chicago burb of about 140,000 people, I have driven through this intersection thousands of times.  The light was green, a simple indicator that I could proceed.  On this particular occasion, however, someone was blasting through the intersection, against the light, at a high rate of speed.  As a cautious old guy I have learned not to depend on the simple heuristic of the green light.  The younger Jeff (and a lot of cell-phone gabbing teenagers in my neighborhood) might have had a serious accident.  But since I understood the underlying mechanism of the traffic signal I know that it is only an indicator of probable safety.

Earlier this month I heard the DuPage County sirens go off, indicating a tornado or disaster of some sort.  This is an important warning system, since there have been major tornado disasters a few miles from my home.  We take the warning seriously.  I glanced at the clock and noticed that it was 10:00 AM on the first Tuesday of the month, and remembered that this was the normal monthly siren-testing time.  By understanding the underlying mechanism, I realized that the indicator did not have its normal message.  (Some day there will be a tornado or disaster at exactly that time, but that is another problem).

The point for stock market observers is that there is danger in blindly following heuristics.  By paying attention to the underlying mechanism, called a causal model in social science research, one can avoid mistakes.

I understand that many of my readers behave just as I do in many real-life situations.  The question is whether they take that experience and apply it when they have a question related to the market.  I will provide examples where many Wall Street types show blind adherence to simplistic rules.  In fact, the example occur daily on CNBC faster than I can record them!

Please note the point.  I am not saying that those following the "rule" are wrong.  I am saying that without knowing the causal model, they do not know whether they are wise or blind.

Down with Slogans!

One of my New Year’s resolutions is to wage a war on slogans.  I hope to help my readers to see how they can gain edge through a Contrarian approach to slogans.  This will take a series of posts with different subtopics and examples.  Partly it is my effort to put down pieces of a longer work in progress.  Partly it is inspired by Barry Ritholtz’s excellent series (which I expect will be a successful book at some point) The Apprenticed Investor.  You can and should read these articles.

So what is my mission?  Here is a typical conversation among those analyzing the market.  It may occur on CNBC, on professional sites, on blogs, or on forums.

A:  I think that this is not like a typical Fed tightening sequence (or inverted yield curve, or economic recovery cycle, or energy spike, or trade deficit, or many other things).

B:  Are you suggesting that something is different?

A:  Well, it does seem to be different…..

B:  Gotcha!!  You said the magic phrase, "It’s Different this Time."  That shows that you are a hopelessly inexpierienced, clueless, newbie who does not realize that things are never different.

A:  (Apologetic and hanging head) Oh… well it does seem different.

B:  Don’t you know that we all got buried in the bubble because we thought it was different?

And so forth.

Here on "A Dash" my intention is to show readers how to tell when things really are different and why this is important to know.

Some of my kind friends over the years have said that I have a knack for taking complex topics and making them clear to my audience.  I am probably better at doing this in public speaking, but I am going to attempt it here anyway.

My normal method, familiar to professors teaching research methods, is to take a blindingly clear example unrelated to the problem at hand.  With understanding of this in mind, one then tries to show the audience the similarity to the current problem.  If someone thinks that the examples or method are too obvious, then a pat on the back is in order.  Anyone who gets it already is way ahead of most consumers of stock market research and analysis.

Let’s start by getting rid of the dismissive nature of the "This time it’s different" putdown.  There is no advantage in following the slogans of everyone else.  If you are a sophisticated player in the market, it is your mission to discover when it really is different.  It is my mission to suggest places where that might be true.

P/E vs S&P 500 (50 Years)

Take a look at this great chart of P/E versus the S&P 500.  It does a wonderful job of setting up the valuation question.  You can see what is wrong with it, even without looking for a better model.  The trailing P/E ratio method is poor both descriptively and prescriptivey — the two reasons we look for relationships.  It is exciting in that it explains why the parade of talking heads have been saying for years that the market is overvalued, and lets you judge the wisdom of their statement.

Take a look at the chart, courtesy of Mike Panzner via Barry Ritholtz, and then we’ll analyze it more carefully.

Link: P/E vs S&P 500 (50 Years).

As promised, today brings us to the 4th in our series of charts: P/E vs SP500click for larger chart courtesy of Mike Panzner, Rabo Securities I’ll get into the significance of what this means to the markets later, but for now, note where the P/E is over …

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