Tag Archives: income

Alpha On Steroids, AKA ‘Microwave Alpha’

In the Paradox of Skill , author Brad Steiman accurately proclaims that ” confirming skill takes an investment lifetime, and you can never be fully confident that the alpha is not random. ” Alpha is the intercept in a regression of fund performance versus a benchmark. It measures success across time, and that is why it takes so long — you need a lot of observations (time periods) to gain significance. As shown in the following picture, it takes more than 140 years to identify the skill of a low-skill manager, and even an extraordinary manager will take 20 years to manifest statistical significance, and by that time the management might not be the same. Click to enlarge Nonetheless performance evaluators continue to use alpha as their skill barometer without ever questioning its meaningfulness. No one wants to wait decades, so we ignore the underlying theory. “Alpha” sounds like science, being a Greek letter and all, but there’s little science in its actual usage. But don’t despair. There is a new and better approach that can deliver statistical significance in a much shorter period of time. Call it alpha on steroids, or microwave alpha — shortening decades to years. The breakthrough determines statistically significant success in the cross-section rather than across time. I’ve written about this approach in Real Long-Only Due Diligence and Real Hedge Fund Due Diligence . A portfolio simulator creates all the portfolios the manager might have held, selecting stocks from a custom benchmark — thousands of portfolios. A ranking in the top 10% of this scientific peer group is significant at the 90% level, even if it’s for a short period of time, like a quarter. To state an extreme example, a return of, say, 1000% is significant, and you don’t have to wait 50 years to declare it significant. This process creates what I call “Success Scores. ” A statistician would call them “p values.” A ranking in this scientific peer group is the statistical significance of performance above the benchmark. Of course it’s still important to get the benchmark right, which means custom is highly advised. So you have a choice. You can continue to use alpha, but you really should wait the requisite time before you invest, or you can use Success Scores. An additional benefit of Success Scores is that they replace peer groups with their myriad biases, including “Loser Bias” caused by the fact that most members of peer groups underperform their benchmarks, creating a race against losers. 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.

What Makes A Stock Go Up (Or Down)?

When it comes to the stock market, one thing is for certain: stocks go up and stocks go down. The question is: what makes a stock go up or down? What makes a stock go up or down is determined by the recent operating results of a business and its future expectations. This means stock prices reflect both fundamentals (operating results) and emotions (future expectations). When either one or both of these change for a particular stock, its price will be affected. What Makes A Stock Go Up (Or Down)? It’s impossible to pinpoint exactly what makes a stock go up or down on a daily basis. To borrow a phrase from The Princess Bride , “Anyone who says differently is selling something.” On the other hand, it’s quite simple to see what makes a stock go up or down over time. Stock prices are based on how investors think a company will perform in the future compared to how the company is performing now. In any investment, investors are betting on the future. Because the future is uncertain, stocks cannot be priced based on a business’s current operating results alone. They must be valued by predicting future performance. Price Ratios In order to quantify these predictions, investors use price ratios. Price ratios are simple tools which show how a stock is priced compared to its recent operating results. For example, a Price-to-Earnings (P/E) ratio of 10 says that a stock is valued 10 times higher than its current earnings. This does not mean that investors expect the company’s earning to increase by a multiple of 10 in the near future. It merely means that if the earnings were to stay constant, investors would break even on their initial investment after 10 years. In other words, the earnings yield on the principal is 10% (10/100 = 0.1). Say a stock has a P/E of 50 and investors still expect to receive an earnings yield of 10%. Paying 50 times earnings only makes sense if the company’s earnings are expected to increase substantially over time. Multiple Futures No matter how badly stock analysts pretend to be fortune tellers, no one can accurately forecast a company’s future performance (especially on a consistent basis). Charles Duhigg, in his book Smarter, Faster, Better: The Secrets of Being Productive in Life and Business , summarizes the reality of what the future is. Duhigg says, “The future isn’t one thing. Rather, it is a multitude of possibilities that often contradict one another until one of them comes true.” These multitude of possibilities are what cause price ratios to fluctuate so often for any one stock. Although there are countless numbers of possible futures when considering a stock investment, there are really only three general scenarios. Scenario #1: A company’s operating results will increase. Scenario #2: A company’s operating results will remain constant. Scenario #3: A company’s operating results will decrease. The level of a stock’s price ratios is determined based on which scenario investors anticipate will come true for that particular stock. Scenario #1: High price ratios. Scenario #2: Average price ratios. Scenario #3: Low price ratios. Operating Results Before getting too focused on price ratios, it’s important to remember that change in operating results is the second half to determining what makes a stock go up or down. Say a stock is reporting earnings per share (EPS) of $5 and has a P/E of 10. The stock would be valued at $50 per share ($5 x 10 = $50). Then, the company unexpectedly reports EPS of $5.50. If the P/E stays at 10, the stock is now valued at $55 per share. To summarize, stock prices go up or down depending on changes in operating results and the levels of its price ratios. The interesting thing is that changes in operating results most often trigger changes in price ratios. Because the future is hard to predict, operating results often differ (sometimes greatly) from what investors expect them to be. When a surprise like this happens, future expectations are reconsidered and price ratios are modified. Impact of Surprises In David Dreman’s book, Contrarian Investment Strategies: The Psychological Edge , he notes the impact of such surprises. Here is Dreman discussing the market’s reaction to unexpected results: Several researchers have found that when a company reports an earnings surprise (that is, a figure above or below the consensus of analysts’ forecasts), prices move up when the surprise is positive and down when it is negative.” It makes intuitive sense that stock price adjustments correlate with positive or negative surprises. Not only do the surprises reveal a change in operating results, but the change in operating results affect the future expectations of the company. This explains why value stocks (low price ratios) outperform growth stocks (high price ratios) over time. Value Goes Up, Growth Goes Down Low price ratios anticipate negative futures (decreased profits) and high price ratios anticipate positive futures (increased profits). Therefore, stocks with low price ratios have more upside potential. On the flip side, stocks with high price ratios have nowhere to go but down. In Contrarian Investment Strategies , Dreman references several studies which show that positive surprises impact value stocks greatly but only minimally affect growth stocks. The studies similarly show that negative surprises impact growth stocks greatly but only minimally affect value stocks. Here’s Dreman explaining the impact that both positive and negative surprises have on growth stocks: Growth Stocks: Positive Surprises Since analysts and investors alike believe that they can judge precisely which stocks will be the real winners in the years ahead, a positive surprise does little more than confirm their expectations.” Growth Stocks: Negative Surprises Investors expect only glowingly results for these stocks. After all, they confidently – overconfidently – believe that they can divine the future of a ‘good’ stock with precision. Those stocks are not supposed to disappoint. People pay top dollar for them for exactly this reason. So when a negative surprise arrives, the results are devastating.” And here’s Dreman explaining the impact that both positive and negative surprises have on value stocks: Value Stocks: Positive Surprises Those stock moved into the lowest category precisely because they were expected to continue to be dullards. They are the dogs of the investment world and investors believe they deserve minimal valuations. A positive earnings surprise for a stock in this group is an event. Investors sit up and take notice. Maybe, they think, these stocks are not as bad as analysts and investors believed.” Value Stocks: Negative Surprises Investors have low expectations for what they believe to be lackluster or bad stocks, and when these stocks do disappoint, few eyebrows are raised. The bottom line is that a negative surprise is not much of an event.” Fundamentals Change Expectations These scenarios explain why value stocks have nowhere to go but up, and growth stocks can only go down. If a value stock’s fundamentals unexpectedly increase, not only will its operating results improve, but investors’ future expectations will be raised as a result. Contrarily, a growth stock’s fundamentals are already expected to increase. Any improvement in operating results is already priced into the stock. Decreased operating results are already priced into value stocks but not growth stocks. Unexpected poor performances wreak havoc on growth stocks, but not value stocks. Buy Value Stocks Because human emotion plays a critical role in what makes a stock go up or down during the short term, investors are wise to invest where expectations are low and positive surprises are likely. To paraphrase a line from The Wolf of Wall Street, “It doesn’t matter if you’re Warren Buffett or Jimmy Buffett, no one knows if a stock will go up, down, or sideways.” We can know, however, which stocks are more likely to go up. Buying stocks with low price ratios is a time-tested approach to achieving superior investment returns.

Fear Of A ‘Black Swan’ Event Is Worse Than The Actual Event Itself, Study Shows

Originally posted on May 3, 2016 Are investors more frightened of freak market crashes than the reality of such crises? Sometimes fear of a freak, outlier event can be a lot worse than the event itself, at least when it comes to the markets. Most of us are aware of the now famous credit crisis book by Nassim Nicholas Taleb , “The Black Swan: The Impact of the Highly Improbable.” The central thesis of the book is of course that black swans , or freak market events, are more common than we expect in life, and in particular, in complex systems such as economics. The credit crisis was, therefore, no great surprise, and such crises can be expected to occur in one form or another on a fairly regular basis. Well, that was Taleb’s thesis. But it was also a thesis written at the height of negative market sentiment. Subsequent serious academic work reported by Bloomberg by William Goetzmann, Dasol Kim and Robert Shiller looked at 26 years of survey data to test Taleb’s thesis. They found that people consistently expect things such as stock market crashes and earthquakes to happen more frequently than they really do. In other words, there may be black swans out there, but more important perhaps than their occurrence is our exaggerated fear of their occurrence. There are indeed periods of irrational exuberance when we forget about the possibility of black swans. But certainly since the credit crisis , it seems that there has indeed been an exaggerated angst that has gripped the global investing community. It is as if the crisis was sufficiently intense that it set off a type of Post-Traumatic Stress Disorder among investors, leading to everyone seeing specters around every corner. This overarching sense of angst has had very significant effects since the credit crisis. Although there has been modest growth in gross domestic product in the United States ever since 2009, the recovery hasn’t felt like a recovery. We continue to suffer what economist Joseph Stiglitz calls the “great malaise,” a lack of those animal commercial spirits. Shiller himself sees this anxiety as driving this very low rate environment as most investors and banks keep the bulk of their assets in low-return fixed-income assets, which itself further lowers the yield on said assets. This has also driven excess regulation. No one can say that the credit crisis didn’t merit a significant re-think of various parts of the U.S. financial regulatory architecture. But it is now becoming equally clear that the Dodd-Frank Act was a behemoth of a piece of legislation, 848 pages long, most of it with half-baked concepts that were left to be developed over time by sub-legislation. Many now expect the very framework of large chunks of Dodd-Frank to require major re-engineering, given its excessively controlling and complex features. The idea, for example, of bank living wills was probably a non-starter from day one. The concept was that banks must put in place plans for their orderly wind down in the event of financial failure, ones that didn’t rely on government support. But this was immediately a bizarre exercise for all financial institutions because it involved making up totally theoretical failure scenarios, some concatenation of events that is unlikely to have any bearing on the actual features of any next crisis. After all how on Earth could we predict what that crisis will really entail? The Federal Deposit Insurance Corp. and the Federal Reserve made all the banks write their living wills twice, on the basis that they were too loosely drafted the first time, but more granularity here doesn’t solve the conceptual problem. The situations conceived are so hypothetical that these living will models are often the case of garbage in garbage out. In addition, for those institutions that matter – the systemically important financial institutions – living wills are a particularly absurd exercise because, by definition, these large financial institutions are simply not sustainable during periods of acute illiquidity without government support. It seems, in other words, that Dodd-Frank itself was premised on their being black swans everywhere. And the capital requirements it imposes on banks, the compliance burden, the business line restrictions and high levels of liquidity buffers all mean that banks simply haven’t been meeting much of even the legitimate credit demand in the United States. The result, of course, has been huge growth since the crisis of the shadow lending market, which is legitimate lending done by non-depositary institutions. The shadow lending market has gone through a total re-birth since the crisis, as multiple research papers demonstrate. There can be dangers of an excessively large non-bank lending sector, but again Dodd-Frank has embedded within it another mechanism for seeing black swans in this sector also. That is the Consumer Financial Protection Bureau . The role of the CFPB in supposedly protecting borrowers from predatory lending is only just being defined now by the regulator. But there is already considerable confusion about the CFPB’s ambit, and, indeed, even a recent court hearing indicated that the bureau may be acting outside the scope of the Constitution. Meanwhile, the U.S. economy struggles to get above 2% GDP per annum, consumer inflation is negligible and growth is so anemic that the Fed’s attempt to raise short rates and normalize monetary policy is materially struggling. So it is back to Shiller and Stiglitz, just too much fear in the system to allow growth really to ignite. And so what does such economic neurosis really amount to? It isn’t necessarily the product of there being too many black swans but the product of an irrational belief that there may be too many black swans. And the big question then is when will it all end? When does the anxiety end, when is the neurosis cured and how? Disclosure: Jeremy Josse is the author of Dinosaur Derivatives and Other Trades , an alternative take on financial philosophy and theory (published by Wiley & Co). He is also a managing director and head of the financial institutions group at Sterne Agee CRT in New York. Josse is a visiting researcher in finance at Sy Syms business school in New York. The views and opinions expressed herein are those of the author and don’t necessarily reflect the views of CRT Capital Group, its affiliates or its employees. Josse has no position in the stocks mentioned in this article.