Not Expensive vs cheap

Barry once again has his finger on the key stock market issue.  (And congratulations on the recogition by a major trading publication.)  Why have we had several years of excellent economic growth accompanied by reduced budget deficit projections, stellar corporate profits, and vastly improved corporate balance sheets without a concomittant increase in stock prices?

His answer, unfortunately, is a tautology.  We have had multiple compression.  The PE multiple accorded to the market is lower because — well — because we are in a "cycle" of lower multiples.  This is not an explanation.  Take a look at Barry’s provocative post and the comments, particularly considering the views of the anonymous "ss."

Link: Not Expensive vs cheap.

This quote is typical of sell side rationalization: “One of the things that makes this market confusing is that some valuation gauges clearly indicate this market is cheap. James Paulsen, chief investment strategist at Wells Capital Management, recently …

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A Complaint from the Peanut Gallery

My reader [sic] complains that the OldProf is not offering any easy answers.  He is too pedantic.  The ideas are too complicated.  Even if I point out errors that represent market inefficiency, there is no easy way to profit.

Well —

First off, I am writing down my observations about the market because there is a book there somewhere and I would never write it in the traditional sense.  I have a few main themes.

  • Individual investors do a poor job — proven by behavioral finance literature and many studies.  This is not new.
  • Wall Street professionals work with a major handicap.  They must satisfy ill-informed individual investors in the short run.  If they do not, they lose investors, or their jobs, or their subscribers.  They are forced to act as if they are in tune with the current market even if that is statistically impossible.  This is a new idea, I think, and one that I will develop further.
  • Big money mangers wind up chasing performance, doing window dressing, and using models that only cover the last few years because that is the only way to attract funds from ill-informed investors.  The most frequent question of an investor is "How are you doing this year?"
  • Actual investment results from brilliant theoreticians and managers may lag for a signficant period of time — longer than the patience of investors and bosses.

In short, there may not be an easy answer, but there might be some answer.  That is where I am going with this blog to be book.  I am mostly writing for this purpose.  When I get around to editing the pieces, I will aim it more carefully at the individual investor.  For now, my reader will just have to consider the pieces.

The Inherent Problem in Stock Market Research

There is a dilemma in most stock market resesarch.

One the one hand, any theory is hungry for data.  It takes many, many cases to demonstrate a relationship with confidence.  Complicating this is the idea that one  should only look at part of the data, and use the rest of it for out-of-sample testing.  Those trying to develop trading systems have a basic awareness of this problem.  Those who operate as "market strategists" often do not.  They take all of the available data and draw a conclusion.

On the other hand, many problems have very few historical instances.  The study of market tops, market bottoms, Fed rate increases, and the like, have a relatively small number of instances even if one goes back decades for the analysis.

The problem?  The old data are simply not relevant.  Looking at stock market data from a hundred years ago is like looking at baseball statistics from the dead ball era.  Would you try to compare Ty Cobb to Barry Bonds or Albert Pujols?

When the world changes, the old findings may not matter.  Arguing that these data are relevant puts a major burden on those advancing the research, a burden that they typically ignore.

Here is a short list of things to think about:

  • In the 70’s the options and futures markets developed.  Everything changed, as major players had large derivative positions.
  • Decimilization and lower commissions have made it much easier for investors to switch positions.  The entire psychology chanced.
  • Tax law changes have altered the incentives.
  • ETF’s have people (investors, their advisors, and fund managers) trading in stocks where they know nothing about the underlying fundamentals.
  • Program trading makes up much of the volume — over 70% in some reports.  What does this do to any technical analysis that uses volume as an indicator?
  • Information has changed dramatically.  Even investors who do not know how to follow a particular stock have access to many opinions about it in a short period of time.  Do we really want to compare this with what people knew during the Taft Administration?

The conclusion is that many propositions cannot be effectively addressed through quantitative research.  There are not enough cases that are relevant.  Trying to do this anyway means that one is making a big decision based upon little information of dubious quality, another way of being Fooled by Randomness.