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Looking for patterns in markets

September 16, 2022

At my son's 8th grade curriculum night yesterday evening, his teacher informed us that the kids would be starting a financial literacy unit. They were going to discuss ways to save and invest. At home, I asked my son if he was interested in savings accounts or indexing as a strategy to invest the money he makes taking care of the neighbors' cats.

"Neither dad. I'm interested in high frequency trading."

This was not music to my ears, so the discussion went deep into the evening on this topic, which had the positive effect for me of thinking I was doing good parenting, and for him of delaying bedtime. High frequency traders look for patterns. Indexers assume the patterns are all competed away quickly, in part by the high frequency traders. Here is Andrew Lo, Professor of Finance at MIT:

"As soon as you start doing this, the pattern disappears… in financial markets, the moment you try to take advantage of this pattern, the pattern changes. In fact, the more you try to take advantage of it, the more quickly the pattern changes. If there are a lot of people trying to predict patterns — then you get no pattern. You get randomness. That’s the idea behind an efficient market being random. If it were not random, then that means that there aren’t enough people who are bothering to try to forecast the price and incorporate information into the price.”

Indexers believe in the efficient market. That patterns, particularly in the short term, aren't really a thing.

The problem is that patterns help to relieve anxiety. Patterns feel safe, they feel predictable. If you believe you see a pattern in something, you believe you know what's coming next, and that feels good. Much of our lives depends on being predictable and dependable. That's one of the differences of being an adult and being in 8th grade - you don't decide, randomly, that shoes are no longer necessary. The pattern is you put your shoes on in the morning.

In finance, what happens is that people look for patterns, and not just the high-frequency traders. There are endless silly reports from finance firms that say "We see XYZ occurring in the economy, and as such we expect to happen." The problem is there are so many potential patterns that if you look hard enough, you can find almost anything to believe. And how they all relate and affect each other is impossible to predict.

What to do? At least in finance, and probably in life, extending your time horizons to the medium and long term timeframe improves confidence in pattern seeking.

Dan Cunningham

1. This is a great read if you are interested in a high frequency trader, Renaissance Technologies, who did, in fact, beat the market.
2. If some economics concepts seem dry to you, I recommend the Cartoon series on microeconomics or macroeconomics. These are surprisingly good books.

Are Wall St Analysts getting it perfectly wrong again?

August 12, 2022

Surprising no one at One Day In July, annuity salespeople have been out in force this summer. As the stock market dropped into a trough in May and June, annuity sales set an all-time record in the second quarter of $74 billion, surpassing the previous record of $69 billion, which was set, drumroll, at the bottom of the financial crisis. At the same time investors fourteen years ago were busy selling the market at the best time to buy it, Warren Buffett was on the other side of that trade, taking the shares off their hands at cheap prices.

Here is what he said in his famous piece published October 16, 2008:

Today people who hold cash equivalents feel comfortable. They shouldn’t. They have opted for a terrible long-term asset, one that pays virtually nothing and is certain to depreciate in value. Indeed, the policies that government will follow in its efforts to alleviate the current crisis will probably prove inflationary and therefore accelerate declines in the real value of cash accounts.

And perhaps more importantly, followed up with this:

What is likely, however, is that the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up. So if you wait for the robins, spring will be over.

Besides annuity sales, which seem to be a good reverse indicator of how to make money (buy the market when lots of people are buying annuities), what else can we look at as a signal that could have a little predictive value? Here's an idea:

The professional analysts on Wall St seem to be a relatively good signal. The graph above, published right around the recent market low in June, shows that when they get strongly pessimistic on stocks, they seem to be almost perfectly wrong, and returns are quite good going forward. Note that the reverse is not true: when they have been optimistic, it has often also been a good time to buy.

You can imagine the scene at an analyst firm. Mark, the junior analyst who is celebrating return-to-office and trying hard to impress his boss, carefully models the Intel earnings reports this spring, layering in some educated guesses about rumors of government chip subsidies. A bunch of reports get passed around and Sarah, another junior analyst, needs to say something, so chimes in: "the demand is coming off bitcoin miners fast. That dog won't hunt." And Jake the boss, who played a lot of lacrosse in college but doesn't have the faintest idea what a GPU does versus a CPU, can see it's not looking great. "What's the earnings number Mark? Is this landing coming in soft or hard?" And Mark delivers a lower earnings number that he says is backed up by some form of statistical analysis, and throws out a few hedges in case he's totally wrong, and out goes the report.

Investors, according to Bloomberg a month ago, on July 11th, have piled into the downward trend:

The latest flurry of downward revisions probably means little to investors who have slashed their equity exposure to multiyear lows.

As you may know, we don't have much confidence in predictive signals. This doesn't mean it's not fun to read analyst reports six months after they're published and see if they were right or wrong! And sometimes, as above, there can be a hint of predictive ability, though we can't be confident it will hold in all cases.

Dan Cunningham

1. Bloomberg "Stock Drubbings Convince Holdout Analysts to Get Real." 7/11/2022
2. The analyst scene above is apocryphal.

Harold Hamm is not happy

July 15, 2022

Before we get into the discussion topic today, here is some good news that has not been widely reported in the media. In Q2 2022, S&P 500 businesses paid out $140.6 billion in dividends, an all-time quarterly record. While this is in nominal dollars and not real dollars, in other words it doesn't account for inflation, it surpasses last quarter's payout of $137.6B and is up 14% from the same quarter in 2021. Note that the dividend payout increase almost *doubled* inflation year-to-year. At the same time, the index is about 10% cheaper to purchase.

Harold Hamm, 13th child of Oklahoma sharecroppers, mild Internet celebrity for writing perhaps the largest paper check the public has ever seen (1), and founder of oil company Continental Resources, is not happy.

One would think that oil at $100 a barrel would make Harold pleased. But your revenue is your price times your volume, and he thinks he can pump more oil. A lot more. The problem is that his public company investors do not necessarily want him to do so, in part for environmental reasons, and in part because they have different incentives. So Harold is trying to buy out the 17% or so of the firm he does not own. This presents two interesting cases, one for the environmental investor, and one for indexing investors.

1. On the environmental side, many of the large Wall St firms, and mutual funds, are now structured to consider environmental variables in their investments. Whether those variables are accurate is a point of discussion, but this industry exists (see One Day In July environmental options here), is growing fast, and has over $35 trillion under management worldwide. The interesting thing is that it's large enough, and powerful enough, to have some influence over a firm like Continental. Just because Harold wants to drill, doesn't mean he gets to.

On the other hand, Harold didn't rise from an Oklahoma pickup truck at age 21 to running Continental by obeying people when he's told "no." So his response is to take Continental private. Maybe it will be his family's money, maybe he'll invite in some rich friends, but one thing that will not happen is the public and the stock index will not share in the profits as he cranks up production. The profits will flow to a very small number of very wealthy people. The environmental investor says: "we want to reduce carbon output" and Harold says "my oil is getting kids to soccer practices, and because we frack America doesn't need Putin's energy." The values are different (at least on the surface) and as such, everyone is maximizing to their priorities. The environmental fund gets better metrics but perhaps worse financial performance without Harold's firm around, and Harold gets more money.

2. This particular case also outlines a weakness in corporate governance and indexing. We've discussed this deficiency in a cursory way in this newsletter previously. One of the problems in indexing is that large funds have common ownership across firms. If you're the indexed investor, in a financial sense you care about the aggregate profits of the index. High prices at the pump may not bother you, as the margins and profits of each barrel of oil are high (2). As the indexed investor you might think "leave the oil in the ground, I'm making just as much money anyway - I'm not going to make any more if production increases, and then there will be more carbon." The oil company executive has a different point of view of course, seeing no value in cartel-like behavior.

This is an easy problem to solve by removing voting rights for index investors. They can ride along but they don't get a management say. That has not happened yet but hopefully it will.

Note that the two issues above surface in many industries. As one example, imagine that a building produces cash flow of X. If you are an indexed REIT holder, and one of the REITs in your index owns the building and sells it to another firm of similar size and capital structure in the index, your cash flow has not changed as the indexer. But the cash flow of the underpinning firms has morphed substantially.

Credit to Matt Levine from Bloomberg who wrote about the two ideas above. We've discussed them a lot with clients over time, and they converged in this example.

Dan Cunningham

1. Clients often ask if large checks, such as IRA Rollovers, will clear if they are in paper form. The answer, based on Harold's check, is yes.
2. This is a simplification of course, as high energy prices tend to negatively affect other industries, which are also represented in the index.
3. Dividend information above source: Dow Jones Indices data.

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