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Posted 11/15/2001
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The Speculator
You make money by breaking the rules
A new book that culls investing rules from more than 150 experts is often amusing and admirable. But a closer look at some of the most hallowed rules shows its limits for investors.
By Victor Niederhoffer and Laurel Kenner
Oscar Hammerstein, who wrote the lyrics for “There is Nothing Like a Dame,” might have put it this way:
- There is nothing like a
rule
Nothing sounds so cool
There is nothing that can fool
That is anything like a rule.
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Editors Philip Jenks and Stephen Eckett have provided an invaluable service in eliciting contributions from 150 “master investors” culled mainly from the tribes of money managers, academics, industry experts and writers of market letters in America and Europe. Jenks and Eckett claim that no other book has put together a roster of such high-caliber contributors, and, except for the inclusion of the co-authors of this column (who stick out like sore thumbs in the august company), we agree with their self-evaluation.
The trouble with rules
The problem with these rules and all similar rulebooks, however, is that it's hard to differentiate the good rules from the bad, the rules that worked at one time from those that have stopped working, the rules that are true in all situations and are basically banal tautologies from those that have some sharp focus and explanatory value.
What would be ideal in a compilation such as this would be to find testable hypotheses on important non-random tendencies in the market, with the relevant historical period and specific estimates of magnitude and uncertainty attached to the conclusions.
If this were combined with some attention to the ineluctable principle of ever-changing cycles, the reader would be on third base in his quest for making some extra profits. As it stands, we’re afraid he’s still going to be at the batter’s box, but at least (after a careful and judicious reading) with a proper bat and stance.
Nonetheless, one of the valuable things about the book is the wide coverage of specialized fields with recognized experts, each of whom has unloaded 10 or so rapier-sharp rules.
To name but a few of the distinguished contributors: Bob Dischel, a consulting meteorologist on weather; Jeremy Grantham of Boston’s Grantham, Mayo, Van Otterloo & Co. on investment management, Bill Gross of PIMCO on bonds, Steve Harmon, a top tech analyst on tech stocks; Roger Ibbotson on asset allocation, Dean LeBaron, founder of Batterymarch Financial Management, on investing habits; Viren Mehta, a pharmaceutical expert, on innovative therapeutics; Thomas A. Petrie, a top oil analyst, on energy; and Richard Thaler of the University of Chicago on investing mistakes.
Despite the wisdom and wealth of the contributors, the book is marred by the non-testable nature of 90% of the rules. It is a standard tenet of science that knowledge cannot advance without a theory that leads to falsifiable predictions.
Just three of the rules included numbers:
- David Fried, editor and publisher of The Buyback Letter, said the average annual return of companies that buy back their shares is 8% higher than for companies that don’t.
- Jay Ritter, a University of Florida finance professor, said initial public offerings (IPOs) underperform the market by 4% a year during the first five years after issuance, with the underperformance starting six months after the IPO.
- We noted that corporate officers and directors make an extra 3 percentage points on their buys and an extra 3 percentage points on their sells. ( A complete list of our rules appears here.)
Sell short the stock of any company with a former or future senator from Tennessee on its board: Robert A.G. Monks. Monks, founder of the shareholder activist fund Lens, cites Howard Baker of Waste Management (WMI, news, msgs), Albert Gore Sr. of Occidental Petroleum (OXY, news, msgs) and Fred Thompson of Stone & Webster (SWBIQ, news, msgs), which filed for Chapter 11 bankruptcy protection last year.
Watch the wider world for clues that a trend reversal is due: Donald Cassidy. A senior analyst at Lipper Inc., Cassidy recommends watching cartoons, TV sitcoms and ads, which all reflect “well-established (late) trends.”
Beware financial engineering: John Kay. “Over the long run, the only place shareholder value can come from is cash generated by operating businesses,” says Kay, who has been described as the most important business analyst in Britain.
Challenge the consensus: Catherine Tan. At the top of a cycle, excess capital expenditure is always disguised as productivity increase, observes Tan, a money manager with Lloyd George Management in Hong Kong. “Special mention goes to Singapore’s senior minister, who claimed East Asia’s success was due to Confucian values.”
Goldilocks demographics; not too young, not too old: Richard Cragg. The growth of the 45- to-55 age group, relative to the young and elderly, is the ideal investment backdrop, says Cragg, author of "The Demographic Investor". The best bet from now to 2020 is China, where collapsing birth rates will create a huge bulge in the proportion of 45- to 55-year-olds.
Many of the untested but testable propositions in the book are variants of “The Trend Is Your Friend.” If the book has a dominant rule, this would be it. Here are but a few examples, selected from a few dozen or so:
- The trend is your friend in the last hour. (Alan Farley)
- The trend is your friend unless it is about to end. (Thomas DeMark)
- Never short-sell stocks when they are going up. (Simon Cawkwell)
- Draw trend lines. (John Murphy)
- Frequently, what is low will go even lower, and what is high will continue to rise. (Marc Faber)
Testing one maxim
Continuing on our eternal quest to raise the level of logic and science in the field of investment, we did the unthinkable in our field. We actually tested “The trend is your friend,” which is, of course, the main shibboleth of technical analysis. The test is very simple, the kind of thing that any high-school science student would be required to complete for a passing grade in a weekend homework assignment: Is there a positive or negative correlation between consecutive changes over periods of the length most people mean when they’re talking about a trend?
The actual length of the period is not terribly important, as almost all typical measures of trends within time periods of, say, 20 or 30 days, are quite close to each other. If one measure, say, the 25-day moving average, is up, then the 25-day regression or 30-day line between consecutive lows or what have you is also going to be up. We chose as our measure of trend the move in the last 20 days in S&P 500 futures. To measure the trend’s tendency to persist, we calculated the correlation between the change in the last 20 days and the change in the next 20 days. That correlation is -0.12 over the last eight years
The numbers indicate that when stocks have gone up over 20 days, they are likely to go down over the next 20 days, and when they have gone down over 20 days, they are likely to go up over the next 20 days.
Recall here that the correlation measure is the linear relation between two variables, with 0 showing no relation, 1 a perfect positive relation and -1 a perfect negative relation. The actual level of -0.12 is quite high for correlations involving stock market predictions and indicates a strong tendency to reversal. Thus, our rule to find out what the trend followers are doing and to do the opposite is a good one.
While a negative 12% correlation might not be considered overly large in magnitude, little things have a way of adding up in the stock market. The average S&P 500 futures move in the 20 days after all those occasions when the stock market was down in the previous 20 days is up 0.8%, or about 9 points. The 20-day periods after a rise in the previous 20 days showed almost no change, on average. (For the purists, the average change was -.01%.)
A 6,000-point edge
When you consider that the S&P 500, adjusted to today’s levels, rose some 500 points during the eight-year study period, the 6,000 extra points that an investor would have realized from buying on the 722 occasions when the 20-day average was down can amount to a significant figure. Six thousand points is quite an edge to have.
We doubt that a simple demonstration such as this will be accepted without many objections and diatribes. Something as simple as a test of its validity would naturally be resisted as possibly leading to a new paradigm. While we don’t consider ourselves heroes of the Galileo mold in showing that gravity affects all objects equally, we do consider the state of knowledge in the field of technical analysis much less advanced than that in any of the sciences in, let’s say, the 15th century.
One critique we are sure to hear is that our test is unfair in that it did not use 25-day or 30-day trends. The complaint would have been valid had we not also computed the correlations for longer periods and found that the correlations are even more negative.
It will also be objected that a simple linear measure of association like correlation is not adequate to capture what's really going on in the stochastics, waves, tests, heads and shoulders, and points and figures of the market. But no matter how you cut it, the overwhelming negative correlation would make any effort to overcome it with an ad hoc postmortem totally ineffectual.
Readers will doubtless have other comments on our test, pro and con, and we welcome hearing them. For this, write to dciocca@bloomberg.net. We also will be pleased to send our workout of another untested shibboleth, this one concerning the supposed declines of large growth companies around earnings announcements.
End note
We are completely out of the low-priced portfolio we recommended on Sept. 27, with a 17% gain. Our biotech portfolio, recommended Oct. 25, is up 8%.
Speculator’s holiday
Our column will not appear next Thursday, the Thanksgiving holiday. However, our paean on what caused Thanksgiving is available for the asking. Write dciocca@bloomberg.net. We wish all our readers a safe and happy holiday.
At the time of publication, neither Victor Niederhoffer nor Laurel Kenner owned any of the equities mentioned in this column.
MSN Money's editorial goal is to provide a forum for personal finance and investment ideas. Our articles, columns, message board posts and other features should not be construed as investment advice, nor does their appearance imply an endorsement by Microsoft of any specific security or trading strategy. An investor's best course of action must be based on individual circumstances.