Contrarian Investing

I was inspired by this article to make some comments about investing 'techniques.' To summarize the article, the guy argues that investment techniques like technical analysis (using past price data to forecast future price movements), fundamental analysis (a la Graham, Buffett, etc.; also called value investing), and something called Elliott Wave (no idea) don't work. What he means by 'don't work' is that these methods don't offer reliable systems for generating abnormal returns regularly and reliably. That's fine; that's what Efficient Market Hypothesis says: you can't regularly beat the market, although you can sometimes.

Let me quickly say one thing about value investing, since that's an area of research of mine. It does appear to be the case the value investing methods (i.e. identifying underpriced stocks) generates abnormal returns over time. Why? Stocks become underpriced because of analyst disregard and investor ignorance. Those stocks offer good opportunities for capital gains, but they also tie up a lot of liquidity because price recovery tends to be sluggish. So mutual funds and institutions that need the ability to sell quickly avoid such stocks, making the market for value stocks rather inefficient.

Anyway, the author goes on to discuss the investment technique that he thinks is 100% reliable. He doesn't appear to be selling anything, so I don't doubt that he believes his claim to be true. And it is quite a plausible technique: be a contrarian.

What does it mean to be a contrarian? It means going against the crowd. In investing, it means selling when everyone is buying, and buying when everyone is selling. Except that in the stock market, for every buyer there's a seller, so what it really means is buy when prices are low, and sell when prices are high. Hey, wait, isn't that just the old saw of 'buy low, sell high?' Well, yes it is. And that's really the genius of such a rule. It's old wisdom that nobody follows. Because investors display herding behavior, most of them end up buying high and selling low. The bond buying frenzy of a couple years ago immediately springs to mind. If you're chasing returns, you're pouring money down the drain.

A somewhat more refined view is to look at investor sentiment. Figure out what the herd thinks will happen, and then do the opposite. In this refinement, one would take the view opposing what most people think will happen. If the herd thinks stock prices will be up next week, take a short position, and vice-versa. This technique was articulated in the finance literature by DeBondt and Thaler (1985) and termed 'reversal.' Reversal can exist in the short-run (weekly) or long-run (many months). Reversal has always been suspect, since it is behavioral then the one thing you can trust is for people to be unpredictable just when you want them to be predictable.

So, with this view in mind, I ran some econometrics. Cause that's how I roll. I used the investor sentiment measure (a weekly poll) produced by the American Association of Individual Investors (AAII). They ask people if they are bullish, bearish, or neutral about the market, and then the data is the percentage of total respondents that claim of these three. I use the spread between bullish and bearish as my sentiment indicator. My dependent variable is the weekly return on the S&P 500. I check my work with monthly data afterwards. I run the following model:

Return next week = A*Return this week + B*Spread this week + Error

Spread next week = C*Return this week + D*Spread this week + Error

It's a little technical, but this is a simultaneous equations model of time series (called a vector autoregression or VAR). Essentially it can tell us if the spread has any correlation with the return in the week following, or if the return has any correlation with next week's spread. I go back as far as four weeks (four months to check my work). I find the spread this week is not at all correlated with next week's return. Same with monthly data. Past returns are strongly correlated with the spread, though. If the stock market's been doing well, then people feel it will continue to do well, and vice versa. And the spread itself is highly persistent - the herd doesn't change its mind very quickly or often. 

I refine the measure a bit to check if extremes matter more. So I impose, along with the spread measurement, a measure of when the spread is in the top bullish quartile or top bearish quartile. In other words, is there any predictive ability of the spread when it is quite high or low? Some, but not really. Next week's returns will be higher if the spread four weeks ago was abnormally bearish. So if everyone is bearish, and I buy, then I'll do better in four weeks. But not in the interim. Sounds iffy to me. I find this same result for months, but if the week thing is correct it should appear in the lagged month, not the lagged four months. So I think this is a feature of the data (sunspots), not something we can use to predict the market.

Now, this isn't evidence that disproves this fellow's investing technique. It just doesn't offer any evidence in favor of it. I'd be happy to try different sentiment measures. Incidentally, I did try the University of Michigan Consumer Confidence Index. That's no better than AAII's measure. So I'm not willing, at this point, to give up on old-fashioned Graham.

Government Buys Own Debt?

The WSJ reported yesterday that the Federal Reserve bought nearly 61% of all net Treasury issuance in 2011.  Now, it’s no big secret that this is happening, think QE2, but I about fell out of my chair when I read this article.  So, I have some questions about this rather unique exchange.

1. If the Fed buys Treasury bonds, and those Treasuries generate interest, does the Fed collect interest from the Treasury?  When I buy a Treasury bond, I get semi-annual interest payments and then collect my principle when the note matures, assuming I didn’t’ sell it.  Does the same transaction occur when the Fed buys Treasuries?  So, is the government just paying itself interest?  Seems dubious.

2. Is the Fed printing money? The Fed swears it isn’t printing money, but in essence, isn’t this what’s happening?  The Fed credits electronically the dealers it buys the bonds from, so while it may not be mechanically printing green dollar bills, it’s creating money out of thin air in the form of electronic deposits, no?

3. How long can this continue?  The article says this can’t continue forever but what or who can stop them?  Who knows how large the Fed balance sheet is – and does it really matter, except when it comes time to unload all this stuff.  How can the Fed unload trillions of Treasuries when US Treasury is also selling billions in treasuries?  Are there enough buyers to mop all this debt up?

4.  Isn’t the Fed simply financing the government’s own budget deficits?  This seems so weird and wrong that a quasi-government agency can purchase debt from itself.  How is this stuff even legal?

Perhaps the good Prof will jump in and answer some of these questions.  He may need his own post to do that!  

A Dirty Little Secret

I wonder what government environmental agents would say about a single source of pollution like this that occurred roughly every six months:

• 23 tons of harmful particulate matter get scattered around an area a quarter mile in diameter

• 13 tons of hydrochloric acid killed fish and plants within a half-mile radius

• 28 tons of carbon dioxide are pumped into the air at each occurrence and over 900 times that amount is given off by all the supporting facilities every month

Well, each time NASA launched the space shuttle, this is what happened.  In its hunt for carbon dioxide and other pollutants, the Environmental Protection Agency should probably send their armed agents to NASA.  (Note that we stopped launching Space Shuttles, but nevertheless...)

Gas Prices, Spending, and Recession

I don't need to look at historical gas prices to know when they the gas prices have gotten relatively high. I just have to wait for the hysterical journalists to start warning about impending doom. You know the old saw - high gas prices somehow translate into lower consumer spending and that translates into recession for everyone. Frankly, it's nonsense. Here's a more thoughtful piece: http://www.theatlantic.com/business/archive/2012/03/the-110-effect-what-higher-gas-prices-could-really-do-to-the-economy/254386/ that has much I agree with, and much I don't. So I'll give my analysis of what happens when gas prices go up.

1) The per-gallon cost is up so some people will drive less or just pay a little more and drive the same amount. I personally have found that my total gasoline expenditure in a month doesn't change that much with the adjustments in gas prices. But let's say, for the sake of argument, people don't reduce the miles traveled and opt to spend more of their budget on gasoline. That means less of the budget to spend on other things. We'll assume the savings/consumption/hoarding balance doesn't change and so all changes are within the consumption category.

2) So the standard story is that the reduction in spending on other goods will spell doom for the economy. High gas prices = lower consumer spending, right? Wrong. High gas prices mean equal spending but distributed somewhat differently. But does that distribution really matter all that much? Instead of going on a long vacation, some people will opt to spend time at home. Same amount spent, just on different things. So what? That's natural business fluctuation, and it likely has little effect on real business spending. Companies have cash cushions to deal with that sort of thing. It's long-run changes that affect businesses, not short-term burps and bubbles.

3) What about businesses that use gas and oil? Their costs go up, don't they? Sure, they go up (and down) as gas prices change. Again, there's a lot of seasonality to this, as gas prices increase in the summer and decrease in the winter. But in the short run why should that matter? So margins get squeezed a little bit. If it's not a long-term change then what's to worry about? If your margins are razor-thin, then this could spell losses - but if your margins are that bad, maybe you shouldn't be in business anyway.

4) What about the firms that are earning more money because of higher gas prices? Namely, the refiners and oil producers. Well they have more money, and stock prices will increase. If it's short-run, employment and such won't change much, so again not much of a big deal. Some people might score a nice capital gain, but that's about it.

My points here are to get people to think about all of the effects, not just the decrease in spending on 'other stuff' that results from more spending on gasoline. I also mean to suggest that short-run fluctuations ain't a big deal. Especially not for bigger businesses that engage in risk management through forwards and futures.

By the way, there's no clear effect of gas prices on the unemployment rate:

Even More on Obamacare

From the WSJ - "Solicitor General Donald Verrilli, representing the government, struggled to outline a workable principle that would limit the ability of Congress to require people to make other kinds of purchases in the future."

Exactly. 

It's not that Mr. Verrilli struggled with the words, or had trouble communicating his ideas about a limit.  The problem is that there would be no limit on federal power if Congress can coerce you into health insurance.

More on Obamacare

This week, your liberty is on trial at the Supreme Court.  The Court has scheduled three days of hearings to determine if Washington has the constitutional prerogative to basically rule your life.  Today, the Supremes heard arguments as to whether the provision in the law for not buying healthcare insurance amounts to a tax or a penalty.  If it’s a tax, then generally speaking, you cannot file suit until the tax is collected, which in this case is 2014.  That’s when the mandate kicks in.  This would preclude the court from issuing an opinion until that after that date.  Oddly enough, both sides agree that the Court should rule on the merits now, and that the penalty isn’t a tax.  So, to argue the other side, the Supreme Court booked the services of another lawyer to argue a side neither side agrees with.  As I said, odd.

George Will brought up an interesting point today in his Washington Post column.  The Institute for Justice, like several other “think tanks”, submitted an amicus brief opposing Obamacare on the grounds that it violates contract law.  The IJ said that in order for contracts to be valid, they must be entered into voluntarily.  For if an individual can be coerced into entering into a contract, liberty has been relegated to an antiquated notion.  And Obamacare does just that.  Your mere existence requires that you carry health insurance.  Read the whole column here.

Tomorrow is the big day.  That’s when arguments about the individual mandate begin.  Wish I were there!

Supreme Court rules for Property Owners

Today, the Supreme Court ruled that property owners can take the EPA to court when hit with a compliance order.  In a 9-zip ruling, the Court said property owners don’t have to wait until an enforcement order is issued, but can have judicial review before the EPA begins legal action to enforce a compliance order.  The EPA routinely uses compliance orders and their massive fines (up to $37,500 per day) to bully property owners.  Just ask the Sackett family. 

You don’t have to fully understand all the details.  Just know that the Court recognized the EPA for what it truly is: a bully zealot.  And today’s ruling evens the scales just a little.  Hooray for property owners!