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Thursday, February 3, 2011

Beware purveyors of single-discipline strategies (published in May of 2010 in the SB News Press)

I will be the first to admit that predicting market moves is extremely difficult, and few can consistently, accurately do so.  However, over the past twenty years that I have been investing money on behalf of clients, I have learned a few ways to at least narrow-down the possibilities.  One of the ways in which I have done this is to identify what does not work.  Many of the previous articles I have written, included those on asset allocation, international investing, fixed income investing, etc., are based on what not to do.

In this week’s column, I will explore some of the methods the so-called experts use to make predictions for markets or individual securities, and will outline some of the strengths and weaknesses of each.  I will also provide some of my insights about predicting markets, and discuss why the vast majority of the gurus out there are almost always wrong.

There are many, many methodologies that market pundits use, or claim to use, to make predictions about the direction of the markets or individual securities.  Almost all of them fall into two broad categories: fundamental and technical analysis. 

Fundamental analysis deals with the objective and subjective information about the market or security.  For example, earnings reports for companies, GDP growth for the economy, sales growth for an industry, etc.  There are also things like the strength of a management team, the features of a product, and name brand recognition that are not easily quantified, but are nevertheless important in trying to determine if a company is good, as an example. 

All of these fundamental factors are important, and all influence the performance of the markets and individual securities over time.  Determining how they influence, and to what degree each one influences, is the tricky part. Every once in a while, something new pops up unexpectedly that has a huge influence on the market or security, and was completely unaccounted for previously.  A recent example is the problem with Greece—there may have been some analyst somewhere warning about the potential for Greece to default, but since the government of Greece was lying about their debt, it was virtually impossible to know what was going on until the situation was widely reported.  Interestingly, in this case, investors here had plenty of time to take action, since our markets did not react to the problems with Greece for weeks.

Technical analysis deals with price and volume.  Another common way of referring to technical analysis is charting.  There are literally hundreds of technical analysis formulas for all manner of indicators, from moving averages, to stochastics, to Fibonacci numbers.  The simplest form of technical analysis is simply using a price chart and determining where resistance and support lies—price levels that the market or security tend to have trouble going up through (resistance) or tend to stay above (support).  Technicians will draw lines on the chart at these resistance and support levels, and watch to see if the market or security penetrates one of them.  If resistance is penetrated, the indication is that the market or security will move higher, if support is penetrated, the indication is that the market or security will move lower.

Technicians typically only care about charts; they are not interested in fundamentals.  Fundamental analysts only care about fundamentals, and typically never even look at a chart.  This underscores the point of this week’s column, which is that, in my experience, there is no single methodology I have ever come across that can successfully predict anything in the financial markets over any reasonable amount of time. 

The problem with the financial services industry and with analysts in particular is that they have become super-specialized.  There has been a trend towards specialization in all things financial for at least the past 20 years (since I started in the business).  There are many reasons for this, but I think the main one is that asset allocation programs used by the major brokerage firms “recommend” investments in specific asset classes, so if those managing money do not fit within these same specific categories of investments, they will never raise any money, and will soon be out of business.  This has accelerated and more greatly defined the trend towards specialization over time.  While there are some definite positives to specialization, there are some significant negatives as well.

Because those gurus who are on television every day are so focused on one type of analysis, one industry group, one area of the economy, etc., they have tunnel vision, and in almost all cases are not paying any attention to anything else that is going on outside of their area of “expertise.”  The problem with this is that everything is interrelated—what happens in Greece does matter to U.S. investors; what happens in one industry affects other industries, etc., etc. 

A similar example of this is what got us into this financial market implosion we experienced at the end of 2008.  Those traders playing around with billions of dollars of derivatives on mortgages were only aware of the exposure they were creating, and maybe the exposure of the firm that they work for, but were not aware of the exposure that a hundred other firms had in the same underlying pool of mortgages.  Because they were clueless about the true risk in the derivatives market, they continued to increase their positions and the exposure of their firm to risk, with devastating consequences that we are all paying for today (and will be paying for, probably for the rest of our lives). 

If a technician is only looking at charts (not at fundamentals), he or she could miss something critical to the performance of the market or security they are following.  While it is true that the chart will eventually reflect whatever fundamental change occurs, in my experience, the confirmation from the chart comes too late.  The same is true for fundamental analysis—if there is a technical break-down on the chart, a fundamental analyst may still think everything is great long after the market or security has begun its decline. 

We see this all the time with stock analysts.  They will continue to recommend a stock even as the price drops for weeks or sometimes months, only to eventually change their recommendation from buy to hold or even sell, but only after the stock has already lost a large percentage of its value.  This happens because fundamental information does not always reflect the current or future situation for a company, and by the time the numbers show that things have turned south, the stock has already dropped.  If you have ever wondered why analysts change their recommendations after a stock has already fallen dramatically, this is why. 

The point to all of this is that there is no single method of analyzing markets or securities that works over time, consistently.  The only strategy, in my opinion, that even has a chance, is to combine several different fundamental and technical analysis methodologies.  What is even more difficult is that one needs to find that combination of techniques that is appropriate given the current and future economic and financial market environment within which they will invest.  A set of methodologies that works well under a certain economic condition, such as a period of time when the economy is coming out of recession and entering a recovery, will typically not work once the economy has entered a period of sustained economic growth. 

As I stated above, I have probably done a better job over the years of identifying what does not work rather than what works, and I can tell you that any method of predicting the direction of markets or securities that depends on one type of analysis will not work in the long-run, if at all.  Beware of anyone claiming that they can consistently predict things with astrology, Fibonacci numbers, tea leaves, crystal balls, the length of women’s skirts, who wins the Super Bowl, or the any other single methodology.  The only strategy that might work is a combination of many good techniques, a keen understanding of where we are in the economic cycle, and a strong sense of history.

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