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HARKing Back: Lessons In Investing From Science

Confirm Ye Not Here’s what ought to be a really boring idea – we need scientists in general and psychologists and economists in particular to stop hypothesising after results are known (HARKing, geddit?). Instead, they need to state what they’re looking for before they conduct their experiments because otherwise they cherry pick the results they find to confirm hypotheses they never previously had. The underlying problem is our old foe, confirmation bias . And the solution for scientists and social scientists alike is known as pre-registration. It would be no bad thing for investors to demand a similar process for fund managers and financial experts. Or, for that matter, to apply some of the ideas to their own investing strategies. No No Negatives It’s been known for years that a lot of scientific research isn’t very reliable. There are numerous problems, chief amongst them being the non-publication of negative results: an issue known as publication bias . There’s no kudos in showing that your hypotheses were wrong, so researchers and corporations tend to bury the data, but it’s still valuable information that should be shared: scientists see further by standing on the shoulders of others, we shouldn’t be encouraging them to shrug them off because they’ve got bored. Worse still, though, is the fact that many studies turn out not to be replicable. The ability to re-run an experiment and produce the same result is an absolute cornerstone of the scientific method : science works because it’s not built on faith, it’s constructed out of evidence. If it turns out that the evidence is unreliable then what’s being done isn’t science, it’s more like religious studies with instruments. Or economics. Repeat, Again Once we move to the social sciences then the problems are even worse. Human beings are terrible things to experiment on , being inclined to change their minds, develop opinions about the experiments and to second-guess what the researchers would like them to do, just to be nice. All too many experiments in the social sciences turn out to be flawed because of social or situational factors that didn’t seem important at the time. Given this, you’d think that repeating experiments to make sure the results held would be even more important for psychologists than it is for researchers in the hard sciences. Well, guess again. According to research by Matthew Makel, Jonathan Plucker and Boyd Hegarty , only a little over 1% of psychology studies have ever been replicated. Everything else is simply a matter of faith in the integrity and lack of bias of the original researchers. Which is not science: in the words of John Tukey, quoted at the head of their paper: “Confirmation comes from repetition. Any attempt to avoid this statement leads to failure and more probably to destruction.” Pre-Register The best solution to this we’ve yet found is known as pre-registration: studies have to be registered in advance, and the hypotheses under investigation stated up front before the research is done. This prevents the experimenters from looking at their data after the event and picking out interesting positive correlations which they didn’t control for, but which are likely to get published. Where pre-registration has happened the proportion of studies giving positive results has fallen dramatically: analysis of studies into treatments for heart disease have shown a frightening drop in positive results since pre-registration was mandated: “17 out of 30 studies (57%) published prior to 2000 showed a significant benefit of intervention on the primary outcome in comparison to only 2 among the 25 (8%) trials published after 2000”. Some of this may be because the low-hanging fruit on the subject was picked earlier, but it’s a scary result all the same. It seems likely that because the researchers can no longer consciously or unconsciously pick the results, they prefer they remove the possibility of confirmation bias – and the fall is so dramatic it places the previous results in question. And, of course, it’s not clear how many of those have been replicated. Creative Scientists Pre-registration isn’t universally popular: there is much rending of white coats and grinding of molars over the issue. Opponents argue that it risks putting scientists in a creative straight-jacket. Although when respectable peer reviewed journals start publishing papers alleging the existence of extra-sensory perception based on … “Anomalous processes of information or energy transfer that are currently unexplained in terms of known physical or biological mechanisms” … then you have to wonder whether the creative juices maybe need a touch of reduction – oh, and the results of this experiment don’t seem to be replicable, bet they never saw that coming. So, what other group of people do we know who are given to making ad-hoc hypotheses, investing loads of money in them, and then ignoring the results while cherry picking specific successes in order to publicly claim that they were successful? OK, apart from politicians. Investing Feedback Investors have all of these faults, and a few more. If we truly wanted to become better investors, then we’d pre-register our hypotheses – including our expected timescales – and then measure our results against the results. Doubtless the outcome would frequently be embarrassing, but the evidence that we do have suggests that getting real feedback about our performance is the only way to improve predictive capability in complex systems like the stock market (see: Depressed Investors Don’t Need Feedback. Everyone Else Does ). The other thing this would do would be to force us to face up to the reality that we can be successful by luck and can fail through no fault of our own. In complex adaptive systems, we simply cannot predict every possible situation; we can only hope to be able to predict a little better than average. But a little better is enough to make a turn, so every percentage point improvement we can make is worth it. Commit and Document So I wonder if some enterprising developer out there fancies setting up a pre-registration website for investors keen to improve their returns, rather their personal status? Public commitment backed up by a positive rewards system has been shown to produce powerful results in a whole variety of situations. For example, in Tying Odysseus to the Mast: Evidence from a Commitment Savings Product in the Philippines , Nava Ashraf, Dean Karlan and Wesley Yin showed: “Commitment-treatment group participants have a 12.3 (9.6) percent higher probability of increasing their savings by more than 20 percent after six (twelve) months, relative to the control group participants, and an 11 (6.4) percent higher probability of increasing their savings by more than 20 percent, relative to the marketing group participants. The increase in savings over the twelve months suggests that the savings response to the commitment treatment is a lasting change, not merely a short-term response to the new product” I suspect that even a non-financial reward system based on peer support would facilitate uptake. HARK, hear… Avoiding HARKing is the future of the hard and the soft sciences. And, by analogy, as investors, if we don’t have hypotheses about what we’re investing in, then we’re simply the modern equivalents of astrologers. And, if we have hypotheses, we should write them down and test whether they’re right, not simply crow about the random successes and ignore the equally random failures. It’s worrying, of course, that this isn’t already the basic investing process. But to be honest it’s even more worrying that it doesn’t seem to be the basic scientific process. Genius and creativity has its place in all human activity – Kepler came up with his third law of planetary motion by mapping orbits to harmonic ratios , believing these to be a sign of heavenly perfection. But Kepler was a mad genius who happened to be correct, so here’s my hypothesis: relying on mad geniuses for humanity’s future and your family’s well-being is probably not prudent.

What Should You Do In The Next Bear Market Rally?

Bull markets have corrections. Specifically, long-term uptrends often hit roadblocks where stock assets may pull back by 10%, 14%, even 19%. Those who may have been holding some cash typically benefit from buying into weakness at significantly lower prices. Bear markets have bear market rallies . Selling pressure typically abates long enough to allow buyers to push stocks higher by 10%, 14%, even 19%. During long-term downtrends, however, attempts at “bargain purchases” can exacerbate portfolio losses and damage psychological resolve . Consider what transpired in 2008. In the first half of the year between March and May, the Dow rallied 11% off its lows from 11,740 to 13,028. The ten weeks of “good vibes” had convinced many people that the worst was behind them. They were wrong. Now look at the epic one-week period from October 27, 2008 through November 4, 2008. The Dow catapulted from 8175 to 9675 for a monster 18% rally. Surely the worst had to be in the rear-view mirror, right? Unfortunately, many buyers who bought in those early days of November later found themselves with assets worth roughly 70 cents on the dollar. (Again, attempts to eat directly out of a bear’s paw can exacerbate overall portfolio loss as well as kill one’s psychological commitment to market-based investing.) Not surprisingly, there was a third head-fake. The Dow’s late November mark of 7550 jumped all the way back up to 9034 by the first trading day of 2009. That’s a 19.6% bear market rally that, ultimately, failed to inspire investor confidence. “But Gary,” you protest. “The Dow and the S&P 500 are currently trading between 13%-14% off of there all-time highs. How do you know this isn’t just another stock market correction in a longer-term uptrend?” I don’t know for sure. Nobody can. I may have made the case for the strong probability that the market had hit the top in the summertime. (Review August’s Market Top? 15 Warning Signs , or July’s 5 Reasons To Lower Your Allocation To Riskier Assets .) Nevertheless, there are no certainties when it comes to percentage moves for stocks, bonds, currencies or commodities. There’s more. If the Fed came to the rescue on a shining white unicorn with QE4 tomorrow, then a bear market for these two indexes might be stopped in its tracks. That is not an endorsement for quantitative easing; rather, it is an acknowledgement that an open-ended 4th iteration of electronic money creation could indeed inflate asset prices yet again. On the flip side, the evidence for why the bear market likely began in May of 2015 is colossal. For example, in bear markets, impressive rallies fail to recapture former high-water marks. Both the S&P 500 and the Dow failed to eclipse respective highs initially set in May – first in July, then again in October. What’s more, the long-term (200-day) moving averages of the indexes began sloping downward in August-September. The failed rallies as well as the negative slope for the Dow Jones Industrials are shown in the chart below. Failed rallies and downward sloping trendlines are only part of the story. In a bull market, investors embrace a wide variety of different risk assets. People go after growth, momentum, small caps, foreign, high yield, MLPs, REITs, IPOs; there is very little in the way of discrimination. As a bull market matures, many gravitate to the safest and largest stocks, eschewing asset groups that they once owned with reckless abandon; they crowd into fewer and fewer companies in fewer and fewer economic sectors. As a bull market transitions to a bear market, falling prices across an array of individual securities and key economic sectors eventually drag down market-cap weighted benchmarks. An observer of U.S. stocks can see the transition from indiscriminate risk-taking to guarded skepticism via breadth indicators. For example, when the bull market is robust, an equal-weighting of stocks in the S&P 500 usually outperforms the market-cap weighted index. As participation in the bull market wanes, and as fewer and fewer corporate shares succeed, equal-weighted proxies typically under-perform their market-cap weighted benchmarks. Not surprisingly, then, by July of 2015, the Guggenheim S&P Equal Weight ETF (NYSEARCA: RSP ) had struggled to make any progress for eight months, even as the SPDR S&P 500 Trust ETF (NYSEARCA: SPY ) was close to an all-time record high. Similarly, RSP outperformed SPY right up to April of 2015. The RSP:SPY price ratio demonstrates that it has been in a downtrend ever since. Another measure of breadth is the New York Stock Exchange (NYSE) Advance/Decline (A/D) Line. It measures the extent to which advancing stocks are outpacing declining stocks, and vice versa. When the Dow and the S&P 500 are near their highs, but the A/D Line is falling, participation in the bull market is becoming increasingly narrow. It follows that narrow participation by stocks listed on the NYSE regularly precedes bearish downturns. In July of 2015, the NYSE A/D Line’s 50-day moving average crossed below its 200-day moving average for the first time since the beginning of the euro-zone crisis in 2011. (See Remember July of 2011? The Stock Market’s Advance Decline Line Remembers .) The Fed launched “Operation Twist” to lower longer-term borrowing costs in late September of 2011 and, in October of 2011, the European Central Bank (ECB) provided a series of bailouts to ailing countries and banks in the European Union. Today, there are no plans for extraordinary U.S. central bank stimulus, only “gradual” stimulus removal. The ongoing deterioration in the A/D Line since July increases the likelihood that the bear will officially come out of hibernation. Unfortunately, the problems are not solely technical in nature. There are precious few bright spots for the U.S. economy. Manufacturing has contracted for 4 consecutive months. The services sector (non-manufacturing) is at a 27-month low. Major financial institutions have raised the odds of a U.S. recession to 40%-50%. Even strength in jobs data ignore the declines in both household income and labor force participation . There’s another way to gauge economic weakness versus economic strength. Specifically, one can examine the spread between 10-year U.S. Treasury bond yields and 2-Year Treasury bond yields. The spread tends to widen during expansion; it typically narrows when there is economic distress. The current spread of less than 1 basis point (.99) is the narrowest since 2009. Meanwhile, going into 2015, nearly every traditional measure of valuation (e.g, price-to-earnings P/E, price-to-sales P/S, CAPE PE10, Tobin’s Q, market-cap-to-GDP, etc.) placed stocks at extremely overvalued levels. Going into 2016, very little had changed because corporate earnings had declined for three consecutive quarters and corporate revenue had declined for four consecutive quarters. The contraction in both top-line sales and bottom-line profits may not mean as much when treasury spreads are widening and/or market breadth is strengthening. However, when these market internals are deteriorating, fundamental valuation suddenly starts to matter again. Many of my moderate growth and income clients at Pacific Park Financial, Inc. remain significantly less exposed to stock risk than they had eighteen months earlier. Then, the reward for a typical allocation of 65%-70% stock (e.g., large-cap, mid-cap, small-cap, foreign, etc.) was worthy of the risk. Since that time, a gradual scaling back toward our current allocation of 45%-50% stock – only large-cap U.S. stock – has been decidedly beneficial. We continue to own lower volatility securities via the iShares MSCI USA Minimum Volatility ETF (NYSEARCA: USMV ), better balance sheet corporations via the iShares MSCI USA Quality Factor ETF (NYSEARCA: QUAL ) and dividend aristocrats via the SPDR Dividend ETF (NYSEARCA: SDY ). Would I make a tactical decision to lower the current allocation to stock even further? If market internals (e.g., breath, credit spreads, etc.) continue to weaken alongside increasing economic strain, I would use the inevitable bear market rallies to lower the allocation from 45%-50% U.S. stock to 35%-40% U.S. stock. Moreover, I might increase exposure to ETFs that track the FTSE Multi-Asset Stock Hedge Index . The “MASH” Index currently boasts a 20% differential with the S&P 500 over the past 3 months. Disclosure: Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc, and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at the ETF Expert web site. ETF Expert content is created independently of any advertising relationships.

Survival Skill: Distancing Yourself From Counterparty Risks

In a recent article entitled, Whatever You Do, Avoid Major Mistakes , I suggested that investors study-up on the subject of counterparty risk. Under a constructionist definition , the term equates to default risk as defined by the inability of a party to live up to its contractual obligations. The failure of a debtor to meet its obligations under a credit arrangement is a counterparty risk as is failure to perform under a swap or option agreement. A Broader Definition Needed However, for investors, a broader definition of the term is more appropriate to reflect that: a) counterparty risk arises when a major player(s) in a firm’s value-chain fails to perform whether contractually or not, b) the mere thought or mention of default gives rise to counterparty risk, and c) counterparty risk reverberates out from the source of the problem such that it can involve not just two, but multiple parties serially / simultaneously. This more encompassing definition explains a lot of what is going today: China’s faltering economy has seriously disrupted supply chain relationships beginning, notably, with miners as close as Australia and as far away as South America. For example, questions have been raised about Rio Tinto (NYSE: RIO ), Glencore ( OTCPK:GLCNF ) and Freeport-McMoRan (NYSE: FCX ) three of the largest mining companies in the world. The collapse in oil prices has now reverberated well away from drillers to servicing, pipeline, storage and tanker companies, landlords and hoteliers housing field personnel, banks, municipalities, states, and even countries. Take, for example, Kinder Morgan (NYSE: KMP ), the Royal Bank of Canada (NYSE: RY ), or Statoil (NYSE: STO ) / Norway. The gadget business that is over-saturated with products amid slackening demand has created problems along the value-chain including between the likes of Samsung ( OTC:SSNLF ) and Qualcomm (NASDAQ: QCOM ). Bricks retailers such as The Gap (NYSE: GPS ) and Aeropostale (NYSE: ARO ) are beating their brains out over fashion style and space utilization resulting in downstream impact to shopping center REIT’s as in the case of CBL & Associates (NYSE: CBL ). Distancing Yourself from Counterparty Risks It’s therefore understandable that some investors are scared. Stocks and bonds that they thought were fairly valued and perfectly safe are tanking. Moreover, fears are being whipped up by the likes of hedge fund managers who actually have lost their a$$ and are looking down the barrel at significant redemptions. Some would have us believe that the world is going to hell. It’s not. I personally see no reason to sell everything and to blow up an income stream in order to protect principle in these extremely volatile markets. BUT, if you haven’t already, the time is rapidly passing to put more distance between your portfolio and counterparty risks. This begins in one of two ways: a) By stepping back to consider macro changes that are developing / underway and how they may affect your holdings, or b) By taking a micro perspective and ‘looking back through’ your portfolio to ‘see’ what negative consequences may be coming at you from interrelated sectors. The idea is to get away, as quickly as possible, from ground zero. On my end, earlier this year, I took three actions to put more distance between our portfolio and counterparty risks: 1) I sold Corning (NYSE: GLW ) not because I don’t like the company – I really do – but because of concerns about the weakening gadget business, 2) I divested our positions in Chevron (NYSE: CVX ) and Royal Dutch Shell (NYSE: RDS.B ) even though as integrated companies they have fared a lot better than ‘pure plays’ in the oil production business, and 3) I bailed on JPMorgan Chase (NYSE: JPM ) believing that they have not been completely forthright about their exposures to oil and related sectors. In other words, I have concerns that, like other financial institutions, JPM may not have a handle on their counterparty risks. At the same time, I am sitting tight with positions in industries / companies that are more insulated from counterparty risks and whose demand for their products and services is relatively inelastic – military defense contractors, water management firms, and pharmaceutical companies. Also, I continue to make investments in what I feel will be growth areas such as in the fight against migrating tropical diseases. Two Directions to Alpha Like everyone else, I have suffered losses so far this year. However, by moving away from counterparty risks, my losses have been 3 to 4% less than comparable indices. Remember, just as alpha-level performance is doing better than the market when it is up, it is also doing less bad when the market is down. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article. Editor’s Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.