S&P500 and Inefficient Markets
The S&P 500 represents a collection of firms across many industries which are among the largest in market capitalization. These firms are all generally successful and blue chip and choosing among them is like choosing a desk to work at on Goldman Sachs: they are all good and yet they can be very different depending on your own capability to hold onto these stocks or keep working on those desks. The efficient markets hypothesis says basically that information is reflected quite readily in the market so you can’t make money from information in the market at all. Now one might think there is a degree of riskiness of introducing information into the market by buying up shares of a poorly performing stock for example but the efficient markets hypothesis actually ignores that risk and just says that all information is reflected so the market prices are the best value for stocks. You can’t get around the efficient markets hypothesis unless you have some way of risklessly introducing information into the market and then you can argue that you are introducing information not already reflected in the market because you can take risk that other people can’t. It is a bit similar to a competitive dynamic in college, everyone ends up in a way so similar that the recruiting process on campus is intensely competitive and we generally just become our attributes. Someone from Lehman once asked me what was not reflected on my resume? I’ve realized he hit on the heart of how to make money in markets as the stock price is efficient, it is in a sense a resume that is perfectly valued from the huge numbers of resumes that recruiters receive. However, the interview from that resume is what ultimately matters provided you can afford the stock and most people can who participate in the markets as stock prices are relatively cheap compared to account sizes or there will be stock splits by the company. The interview from that resume is the information behind that stock that is already reflected in the stock price just like all the interview material is already reflected in your resume. However people still interview you to verify your resume and look for intangibles. Similarly, we still do a basic background research on a stock to verify the stock deserves the valuation it has and look for intangibles that favor or disfavor the stock. Why might the resume be flawed? Usually it is not because of outright lies but the person may simply not match the resume because he has presented himself in a conventional light on the resume which favors his presentation of himself but a few unorthodox and holistic views of him clearly reveal him as a poseur. Similarly a company which dresses up earnings and shows you growth opportunities may clearly be a bad business, if you do some background research, in the sense they are faking it perhaps because the talent of their staff is not that high. They say you have to fake it before you make it but nonetheless there is a difference between faking while trying to make it and just faking it while working on a completely different direction. For example, someone may get into Citadel the hedge fund in Chicago by saying he is a great poker player and then he works patiently on his real stock analysis skills. That is faking before you make it because I doubt anyone is good enough at poker to really make a difference in stock trading, at the beginning of trading I emphasize, and he is drawing attention to an attribute that is of low importance at the beginning to pump up the value of his resume or stock price. Of course all companies want to increase the price of their stock and have the means to at least affect the stock price, so the efficient market hypothesis isn’t arguing that the stock market is the result of randomness but merely that randomness results when many people compete together at the leading edge of limits on their capabilities. Imagine if there were no efficient markets hypothesis, then we might forecast the market as technical analysts do with waves and waves within waves, concluding that we can make money from waves of supply and demand rebalancing during the business cycle. It isn’t easy to make money. If this were the case, people would quickly rebalance the market so the stock movement is random again, not just that it looks random but that the stock market is random.
Now we might imagine someone who sees patterns in the stock market other people don’t. She hence has information and can make money from her information until the pattern disappears from her own activity. What is this person like? A Human Resources recruiter who can remember everyone’s names and encourage people of talent to apply and take offers from the firm. She makes money in some sense from the human capital that people bring in to the firm when they join. This is evidently not the primary way firms make money since the people have to do work or the firm cannot make enough money to pay salaries to bring in human capital.
So we say there are certain repeatable strategies like jumping from an airplane which other people won’t do because they fear it and they lack the skill to perform it safely. One can argue picking up a nickel from in front of a bulldozer is also a skill like this as you have to know what you are doing before you try, but I think the example of the bulldozer is meant to show you that it doesn’t matter your skill, if you get caught like Long Term Capital Management. These strategies are reliable ways to earn some money as an entertainer who brings people along for skydives. That is akin to what hedge funds do as they take their clients for rides on taking risk while the hedge fund manages the risk so the client faces very little real risk in theory and can just manage his decisions about where to put money based on his own information supplemented by what the hedge fund provides. A hedge fund thus is a financial service much like the government is a service. Both make it easier for people to do things provided these people understand a hedge fund is interested in growing its assets under management and a government is interested in growing the economy usually. So to set up a hedge fund you have to find some financial services you can provide, such as wealth advisory and go from there to bring in assets to manage the risk for, and try to grow while helping the clients feel informed and in control of their money.
This is very different from how a prop trader at an investment bank makes money. He will argue straight up the market is very inefficient because of behavioral phenomenon he is close enough to see among people who call him to ask for prices in the market he makes, and yet we can say we don’t need to take him too seriously as behavioral finance is generally lagging of classical finance. This may soon change. Classical finance can also argue the market is inefficient because information is flowing slowly for some reason. But we would have to argue we can risklessly arbitrage the price towards the correct value, or at least that the risk arbitrage of risky bets is profitable to move the price back to equilibrium and the correct price moreover at where the equilibrium arises.
Is there a correct price? Value investors think so based on relative measures like a miser shopping at a flea market even when he is really a board director, and is just taking pleasure in his returns from buying cheap stuff compared to what they are really worth. Swing traders and scalpers pretty much provide liquidity on the markets and charge for just being there. They, in other words, are moving the market microstructure and get to charge for what they do from investors who are price takers. They are for small funds in the bank and relatively a lot of time on the hands.
The real insight actually comes from daytraders who bring in information from the media into the stock market. Tiger Management former CEO Julian Robertson said to go long the best ten stocks and short the worst ten stocks, and if you can’t do that you shouldn’t be in the business. Can that be done? It turns out what really matters is how to make money from a small asset base as that is the real test of any business when transaction costs are prohibitive and you have to make money from scratch or small savings or a tiny income stream. The way to make money turns out to be generating more from less. The basic premise of daytrading is then flawed that you can generate profits from betting on markets with intelligent decisions about where prices go as the efficient markets hypothesis guarantees you will just create volatility in your profit and loss, and bleed money consistently in a downward spiral from transaction costs. The only way to make money then is to provide a service when you have very little money, and one such service is wealth advisory yes, but another may be psychology for the markets. You calm the markets down and prevent crashes and in the process you can eventually take clients for tours of the market when you calm down their portfolios and earn an income each time. But first you have to manage the risk of upsetting in the markets particularly of the unstable variety. Take stock market economic mania for example which by now I well understand. The cause of mania is always inefficient markets that self confirm to create an asset bubble as just like in poker you can seem right if you made the wrong move in expectation but you win the hand as winning is winning unless you are a gambler who has to play again and might get gamed by a predator. Given an inefficient market, do you still participate? Of course you do, you simply have to use psychology instead of mathematics and that is something I realized when I discovered that the world is bigger than math. There are more things in heaven and earth than in your philosophy, Horacio, from Shakespeare. Under efficient markets, there is no mania but somehow the market becomes inefficient and then it springs to life in a strange fashion and fights to remain inefficient. It resembles an undead aspect like when fragments of proteins become a virus capable of destroying cells and replicating itself within cells it hijacks in the human body. We can’t arbitrage the market back to efficiency using mathematics to inform trades because an inefficient market resists arbitrage and rationality, in what they say is: “you will go insolvent before the market goes rational again.” So given a perturbation, we then have to use psychology not mathematics, or at least psychology in addition to mathematics as mathematics can be said to be about proofs in at least some ways, but psychology is about a reflection in the mirror which tells you much of what you do is already irrational, so why not try to understand it. My general reaction to psychology being played on me usually by Professor Moriarty is: “madness you induced in me? This is Sparta!” And then I kick the psychology messenger into the pit by explaining that if you can’t predict fundamentals, you can’t predict the market but we can clearly predict fundamentals: the market just looks random because we are not allowed to use fundamentals to predict price in the efficient markets hypothesis since all fundamentals are deemed reflected.
In other words, I can clearly predict how you are going to do at a job if I interview you based on your fundamentals. I had no way of knowing which resume would give me the right person beforehand, because I wasn’t allowed to interview you before I interviewed you. So I can predict fundamentals but not necessarily where stocks are going to go. In the average if I can pick fundamentals I will move my stocks in a good direction since the interview is a gate for students on campus to pass through, and stocks too have to pass through the gate of fundamental analysis before they can be picked.
So in short the stock market is like a job, you need to keep working to improve your portfolio. It is not a series of bets. Those who think of it as a series of bets are gamblers not traders. And investors are the ones who aim to construct portfolios like someone grows a little economy, thinking about cross dependencies which reflect in the correlation between assets and the overall volatility of the portfolio. Obviously if you lose a lot on a single stock you will probably dump it from basic human psychology. Traders are the ones who reject the advice to prune losers and ride winners as investors naturally do, but sail against the gods, against the wind, in the storm, to improve their portfolios by working harder than investors in understanding what traders own by fundamentals alone, the sum of which traders try to forecast the future with. Quantitative traders also look at fundamentals just quantitatively. If you want to look purely at price with statistical software that is gambling, and computers are best at that, but if you think you can beat a computer in chess you can try it. Rewards are great since no one thinks you can beat the computer in chess. But I am cognizant every time I gamble I pull a John McCain, and scare everyone by singing something like “bomb Tehran” so I will leave the gambling and the big bucks and glory for you who are interested in trading for money rather than trading as a profession. I will skip daytrading and be an investor, making my little economy from my portfolio, and a trader in working in that little economy to inform “the Market” about which stocks are about to rise or fall merely by my own holdings which influence supply and demand a tiny bit, and how hard I work reflected in the accuracy of the fundamentals I predict. Like a butterfly effect to create a tsunami elsewhere. What are fundamentals for stocks? Earnings? No, free cash flow, because free cash flow is what allows managers to control the price of their stock.