- A previous version of this article was published for OrderFlowTrading.com in June 2014 -
1. Expectations Gap
“Often expectation fails, and most often there where most it promises.” - William Shakespeare
There are predictable patterns of investor errors. These errors are so systematic that the knowledgable investor can take advantage of them. We contend that a long term edge in the financial markets is obtained in the realm of cognitive heuristics. Why, even after all these years, do we still act the same even with superior knowledge? Because we're human...and shaking bad habits is really tough. Also, being surrounded by information is great, but there's a catch: you need to know how to filter the information and use the information. Everyone knows that walking the walk is always tougher than talking the talk. We also get distracted easily, greed/fear set in and complacency sets in...it's tough to stay balanced.
Thus, bubbles are created. Big bubbles like the Tech Bubble of the lat e '90s and smaller bubbles like social media nowadays.
Source:
Nasdaq.com
While
a number of factors influence P/E ratios, the most influential is the expectation for future growth.
Clearly, at the time of writing, investors had a high expectation for the future growth of
Facebook. We’d agree that Facebook might be likely to grow faster
than say...Entravision Comunication, but we are also confident that
Entravision will continue on a growth path for years to come while
providing a dividend that will rise with earnings. The same can’t
be said for Facebook. The company could deliver heroic growth rates
by the standards of any top-tier media company yet still disappoint
investors and fail as an investment given its already-lofty
valuation.
Source: Nasdaq.com
Bubbles
(exhuberance) are very similar in nature. The first of many
destructive characteristics they have in common is the excessive use
of credit. Easy money, used to leverage positions and investments.
Secondly, they grow during periods of complacency, when economic
conditions are stable and confidence is high. That is when prudent
principles are abandoned and people forget the concept of “risk”.
The wild enthusiasm of some days will be met with the equally
unwarranted pessimism of tomorrow.
The
major thesis presented here is that investors overreact to events.
People overprice the “best investments” and underprice the “worst
investments”. This is the main reason why "value investing" still works. We have previously demonstrated how market participants correctnly price in the current and recent fundamentals and news regarding financial assets...so in the near term, the price is "fair" and the direction (trend) is correct. However, market participants, that are caught up in all the day-to-day hustle, also forget to step back and assess the larger picture. How low is too low? How high is too high?
In order to answer these questions, a more in-depth look at longer term financials is necessary, and a certain disregard for the macro view is also necessary. Stocks are different than FX or Bonds. Stocks represent businesses which have physical assets and produce a good or service in the real economy. It's not merely a piece of paper or an account adjustment exercize. Hence, investors can actually extrapolate bad news so much that they push a stock way below the value of it's assets (NCAV style investing) or they extrapolate the growth prospects so much that they push a stock intoall the way to the moon (Growth stories & bubbles).
Stocks in outerspace usually means that sentiment behind them is
irrationally bullish, which also means that analysts' expectations
are through the roof. All this enhances the probability of successive
downward surprizes! Vice versa: stocks that are in the graveyard have
a number of negative expectations attached to them, and they are
expected to perform worse. This enhances the probability of
successive upward surprizes.
Mean reversion, which is the tendency of stocks to revert to a mean P/E and mean EPS Growth over time, is one of the most disregarded aspects of stock investing. This keeps the value premium alive & well. Stocks cannot grow at 25-30-40% forever; and the price cannot be totally detached from the earnings of the company. Over time, the P/E will gravitate towards 15 more or less, and EPS Growth will gravitate towards the rate of growth of the economy + inflation.
A
short term example of what we're talking about can be illustrated on
the EurUsd currency pair. It's a good example of how the market had gradually priced
in negative expectations, and how easy it becomes to shock the market
in the opposite direction.
EurUsd
1H chart. Source: tradingview.com
Looking
at the Euro above, we were in a clear downward move on the back of
negative deposit rate expectations and deteriorating CPI. We get a
0.2% negative beat, which was trumped by a 0.1% beat in unemployment,
giving birth to a short term positive boost. Why? The market had
priced in much more negative news! And the usual psychological bias
repeats itself.
So
going back to our application in stocks, analysts and
experts are too optimistic in times of expansion and too pessimistic
in times of recession. This can give birth to significant longer term
surprizes that can be used to create a sentiment-based investment
portfolio. But based on what?
In
our view, stock market value is driven primarily by earnings, dividends and multiple expansion/contraction.
Here's
the rationale we're creating: filter cheap stocks relative to the
market, and relative to their own industry group. Then scan the cheap stocks' long term fundamentals and stick to the higher quality stocks.
As
you may have guessed, we're
looking to position ourselves in line for positive surprizes.
Surprize
has an enormous, predictable, and systematic influence on stock
prices. The event trigger can be something like unexpectedly positive
news on a mediocre looking stock. People re-evaluate their ideas and
expectations and major price changes can occur. Most frequently, the
event triggers are earnings surprizes. Then, there are reinforcing
events. When things are going well, they are expected to continue to
do so. This is less of an impact and there's more risk of negative
surprize.
Are
we the first to think of this type of strategy? Obviously not! There
are a number of research papers out that have tried to prove this
reasoning.
Above
we have the results of a study done by David Dremer in the 1990s.
Many research papers have followed in his footsteps but he was one of
the first to speak about contrarian investing, and market psychology.
As we can see, positive surprizes on low P/E stocks outperform all
the others. This is practical evidence of the psychological biases
spoken about earlier.
But
if it's so easy to build value-based portfolios then why is
everyone not doing it? It's not enough to know a winning strategy,
you also must follow through. This is where investor psychology comes
into play. And it's a nightmare to follow contrarian strategies when
everyone is saying the opposite! Psychology
is the link between a succesful strategy and a good performance.
Good
Luck!
REFERENCES
1.
Tuckett, D. (2009). Addressing the Psychology of Financial Markets.
Economics:
The Open-Access, Open-Assessment E-Journal,
3(2009-40). DOI 10.5018/economics-ejournal.ja.2009-40. URL
http://dx.doi.org/10.5018/economics-ejournal.ja.2009-40.
2.
Lux, T. (2011). Sentiment dynamics and stock returns: the case of the
German stock
market. Empirical
Economics,
41: 663–679. ISSN 0377-7332. URL
http://dx.doi.org/10.1007/s00181-010-0397-0.
10.1007/s00181-010-0397-0.
3.
Daniel, K. D., Hirshleifer, D., and Subrahmanyam, A. (2004). A Theory
of Overconfidence, Self-Attribution, and Security Market Under- and
Over-reactions. Finance 0412006, EconWPA. URL
http://ideas.repec.org/p/wpa/wuwpfi/0412006.
Html.
4.
De Long, J. B., Shleifer, A., Summers, L. H., and Waldmann, R. J.
(1990). Noise Trader Risk in Financial Markets. Journal
of Political Economy,
98(4): 703–38. URL
http://ideas.repec.org/a/ucp/jpolec/v98y1990i4p703-38.html.
Nessun commento:
Posta un commento