As most of our longer term readers will know, we have issues with the Efficient Market Hypothesis and Modern Portfolio Theory because while elegant, they do not explain the actual market very well. Recently, we were challenged by one of our readers to really dig down and explain what bugged us the most about these two cornerstones of modern investment management.
Our conclusion? The concept that gets under our skin is the conceit that the current market price reflects all the available market information or, to state it simply: the price is always right. We call it a conceit because it assumes that the “Why” is always equivalent to the “When.”
How does this work in practice? If one assumes that the timing behind an investment decision is completely dependent on the reasons why one is making the investment in the first place, the process of making those investments is greatly simplified. One needs only to spread one’s bets widely across a broad range of investments and wait to see what the market delivers.This is the essence of “Buy and Hold.”
In a broadly rising market, waiting for the “rising tide to lift all boats” is a viable strategy. However, since we do not think financial markets are likely to deliver such benignly bullish conditions in the near or medium term, we feel compelled to look more closely at the issue.
Why is there so much emphasis on the “Why?”
Going back to basics, there are a number of questions one could reasonably pose about any investment or investment program. Who? What? Where? Why? How? and When? are all logical starting points.
But most financial media and investment research operations are geared to answer the question “Why?” to the exclusion of all others. Why did the market go up (or down)? Why did this investment soar/crater? Why did this quarter’s earnings miss/exceed analyst forecasts?
And frankly, first prize goes to the simplest explanation while second prize goes to the one who can repeat the explanation to the widest possible audience. The simple explanation, rather than the best explanation, is what investors pay for (through commission dollars, subscription fees and audience share numbers on cable networks). Perhaps that is why much of what passes for analysis on the airwaves, the internet and in our email inboxes feels like “empty calories.”
The hope seems to be that the “Why” will incorporate all the other questions one could ask or that by the time the “Why” explanation is examined closely, attention will have shifted elsewhere.
But like potato chips, these empty calories certainly satisfy the need for instant information gratification but do not necessarily leave one better informed about the state of the market.
“Why” looks backwards
In addition to the race to the simplest explanation, the other problem with the relentless search for “Why” is the rear-view nature of the quest. While we might intellectually recognize that all potential profits and losses actually lie in positioning ourselves correctly for future movements in the financial markets, emotionally, we are obsessed with the need for vindication.
So, as one confronts the daily tide of financial market information, one needs to ask: does this particular nugget of information or analysis merely feed my need to be right or does it actually tell me something new about the lay of the investment landscape?
“When” looks forward
Going back to our starting point, we think that asking the question “When” can help keep us focused on the timeframe which will actually deliver investment returns: the future. The purpose of investing is to fund future liabilities. Obviously knowing what you are investing in and how different factors have impacted the investment in the past are important components to help gain a more complete understanding. But “When” forces us to grapple with the actual forces which determine the price of assets in the financial market. “When” also compels us to think of exit strategies as well. If an investment is attractive to us at the current price, what will make it attractive at some point in the future so that we can reasonably expect to book a profit.
How does all this help us as investors?
Although Financial Markets are driven by the sum total of the emotions of participating investors, the market itself is devoid of any sympathy or emotions. Relying entirely on backward looking explanations to satisfy our emotional need to be right is probably not the best way to extract the returns we will need over the longer term to fund our future liabilities. By recognizing which questions will lead us to unemotional decisions, we can cut through much of the information overload and follow strategies that are not already completely discounted in the marketplace.
To answer our original question: does “Why” = “When”? We don’t think so. We think that the two different lines of inquiry yield different and sometimes conflicting answers about the state of the market. Since time and resources are limited, we would concentrate on answering the forward looking “When” question while the vast majority of investors remain obsessed with the backward looking “Why”.
What are the various Systems telling us?
Broadly speaking, the systems that we follow are showing strength in Energy, Technology, the US market and Small Caps. In the commodity space, we continue to see strength in Agriculture (DBA, JJG, DBC and COW), Energy (UHN) and Silver (SLV). The markets are pointing to a continued recovery in demand and investment in the sluggish US economy and the risk of inflation is a very real concern. Although many of the particulars are different, with two unfunded (by current tax revenue) wars and a massive domestic spending program, one should perhaps start flipping back to the history books to see how the economy developed through the late 60s all the way through most of the 70s. But the risk of stagflation is a big enough subject to warrant its own post.