As we’ve stated in the past, the stock market is dynamic. It
is the living, breathing sum of millions of emotions expressed in one tick.
Having a Chartered Financial Analyst (CFA) designation and having spent a large
part of my career practicing fundamental analysis, it is evident that there is
a dichotomy at times, between the company and its stock price. In practice, one
can tender a full cash flow analysis, pro-forma modeling, valuation reasoning,
etc. that will justify a higher stock price for a particular company, yet the
stock price for that same company continues to decline.
The recent trading action for Apple Computer (AAPL) comes to
mind. When the stock rose above $700 per share, analysts on Wall Street
provided voluminous reports justifying a higher stock price, in some cases
above $1000 per share. Take note the purpose of this candid discussion
regarding fundamental analysis is not to take anything away from that field of
study or to demonize the hard working individuals that provide clients with their
much needed fundamental work. We are simply trying to call attention to
cognitive psychological theory that can influence stock prices.
Having embraced the notion that stock prices are driven in
part by emotions, we took it upon ourselves to delve into the financial field
of behavioral finance. Our mission is to better understand a specific range of
psychological variables and how the resulting emotional reactions of these
variables can impact general market conditions. This has been the foundation of
our investment methodology at JSK Partners.
Expanding Field of
Study
Over the past several decades, the field of behavioral
finance has been expanding. We wanted to highlight a working paper this week
entitled, “Behavioral Portfolio Management” written by C. Thomas Howard. Mr.
Howard is Professor Emeritus, Reiman School of Finance, Daniels College of
Business, University
of Denver and CEO and
Director of Research, AthenaInvest, Inc. The research can be downloaded off the
internet free of charge and is absolutely worth reading.
http://www.cfainstitute.org/learning/products/publications/contributed/Pages/behavioral_portfolio_management.aspx
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2210032
Professor Howard breaks down market participants into two
groups, Emotional Crowds and Behavioral Data Investors. He goes on to define
Emotional Crowds as, “Emotional Crowds
are made up of those investors who base decisions on emotional and intuitive
reactions to unfolding events and anecdotal evidence. Human evolution has hard
wired us for the short run, loss aversion, and social validation, which are the
underlying drivers of today’s Emotional Crowds.”
Behavioral Data Investors, “make their decisions using thorough and extensive analysis of
available data in order to tease out stable pricing relationships. BDIs make
decisions based on what Kahneman refers to as System 2 thinking: effortful,
high concentration, and complex. BPM is built on the dynamic interplay between
these two investor groups.”1
When explaining our behavioral investment methodology, one
of the four laws that dictate our quantitative results is what is irrational
will soon become rational. There is a strong dependency on mean reversion
within our thesis. Our belief has held that the market is rational most of the
time, the equivalency of one standard deviation (68.27%).
The work by Professor Howard puts forth the possibility that
emotions trump arbitrage. His work shows that market fluctuations are dominated
by Emotional Crowds. Excess volatility in the stock market shows the market can
be irrational at times and goes squarely against Modern Portfolio Theory that
states the market is rational with little opportunity to actively provide
superior returns. “The chaotic nature of
the stock
market shows little
outward signs of rationality as prices swing wildly based on the latest events
or rumors. For many investors, the contention that prices are emotionally
determined is consistent with their market experiences.”
He also points to something labeled the Equity Premium
Puzzle. “The Equity Premium Puzzle
research stream provides additional evidence emotions play a prominent role.
The long:term equity risk premium should be associated with the long:term
fundamental risks. Mehra and Prescott (1985, 2002) report that the US stock
market has generated a risk premium averaging around 7% annually from the
1870’s to the present. They argue that this premium is too large, by a factor
of 2 or 3, relative to fundamental market risk, so they coined the term Equity
Premium Puzzle. Over the last 25 years, there have been numerous attempts to
find a fundamental explanation of this puzzle, but with little success.
However, Benartzi and
Thaler (1995) provide an emotional explanation.
“The equity premium puzzle refers to the empirical
fact that stocks have outperformed bonds over the last century by a
surprisingly large margin. We offer a new explanation based on two behavioral
concepts. First, investors are assumed to be “loss averse,” meaning that they
are distinctly more sensitive to losses than to gains. Second, even long:term
investors are assumed to evaluate their portfolios frequently. We dub this
combination “myopic loss aversion.” Using simulations, we find that the size of
the equity premium is consistent with the previously estimated parameters of
prospect theory if investors evaluate their portfolios annually.” (Benartzi and
Thaler 1995)
The observed 7% equity
premium is thus the result of short:term loss aversion and the investor ritual
of evaluating portfolio performance annually, rather than the result of
fundamental risk. Putting these two results together, we conclude that both
stock market volatility and long:term returns are largely determined by
investor emotions.”
In our view there is little question that the market can be
irrational at times. Traders, investors, indeed human beings have certain
behavioral flaws that are inherent in our actions. The paradox with this
situation is that individuals can be “predictably flawed” and that opens the
possibility to take advantage of certain market anomalies.
Probability Investing
When asked about our investment style, we liken ourselves to
probability traders if there is such a thing. Investors share certain
behavioral attributes 2; therefore one can
trace this trading behavior in a type of skewed investor bell curve to attempt
to quantify the probability of a certain market direction. The understanding of
the path of least resistance as it relates to market direction provided us with
the information used to attempt to add alpha through active management.
Superior Returns
“In order to
demonstrate that it is possible to earn superior returns, I turn to the active
equity mutual fund research. This group of investors is one of the most studied
in finance because of the availability of extensive, long time period data. One
stream within this large body of research reveals that active equity funds are
successful stock pickers.3
Rather than focus on
long:term fund performance, these studies examine individual fund holdings and
confirm that a fund’s top stock picks produce superior returns.4
The most compelling
results are reported by Cohen, Polk and Silli (CPS, 2010), which are reproduced
in Figure 1. This graph reveals that a fund’s best idea, as measured by the
largest relative portfolio weight, generates an average six factor annualized
after:the:fact alpha of 6%. What is more, the next best idea stocks also
generate positive alphas. This is evidence that it is possible to build a
superior stock portfolio. CPS did not explore the source of these returns, but
it is reasonable to conjecture that much of the return is the result of a fund
BDIs (buy:side analysts and portfolio managers) taking positions opposite the
Crowd. Probably of less importance is the investment team’s ability to build a
superior information mosaic for the stocks in which they invest.5”
He goes on to postulate that active management
under-performance is actually a function of social acceptance. It is the
emotionally driven investor that will dominate the actions of a disciplined
manager.
Our Methodology
We have always placed a high level of importance on market
sentiment when making our investment decisions. We are not clairvoyant in our
attempts to increase alpha based on our anticipated market direction thesis,
but it is comforting to know that there are tools in place that guide us
through turbulent times. It is this grounding that provides the confidence
needed to go against the grain at times, as being a contrarian investor can
indeed be a lonely job at times.
Bottom Line: We
continue to believe there is a coming market pull-back (<10%) or quite
possibly a correction (>10%) with U.S. equities and are preparing now for
this coming volatility. Our belief has always held that corrections are healthy
for any bull market.
- Joseph S. Kalinowski, CFA
1. Please note that in the last quote, Professor Howard
is referring to the book “Thinking Fast and Thinking Slow” by Daniel Kahneman
2. Trader
attributes include (1) the overconfidence effect, a
well-established bias in which someone's subjective confidence in their
judgments is reliably greater than their objective accuracy, especially when
confidence is relatively high; (2) the overreaction effect, the consequence
of having emotion in the stock market is the overreaction toward new
information. Oftentimes, participants in
the stock market predictably overreact to new information, creating a
larger-than-appropriate effect on a security's price; and (3)the herd mentality
effect, herd behavior is a hardwired human attribute which is the tendency for
individuals to mimic the actions (rational or irrational) of a larger group.
Individually, however, most people would not necessarily make the same choice.
3. See recent articles by Alexander, Cici,
and Gibson (2007); Baker, Litov, Wackter and Wurgler (2004); Chen, Hong,
Jegadeesh, and Wermers (2000); Cohen, Polk and Silli (2010); Collins and
Fabozzi (2000); Frey and Herbst (2010); Kacperczyk and Seru (2007); Kacperczyk,
Myers, Poterba, Shackelford, and Shoven (2001); Keswani and Stolin (2008);
Kosowski, Timermann, Wermers, and White (2006); Pomorski (2009); Sialm, and
Zheng (2008); Shumway, Szeter, and Yuan (2009); and Wermers (2000).
4. There is another research stream that
shows truly active managers are able to earn superior returns. See Amihud
and Goyenko (2008); Brands, Brown, and
Gallagher (2006); Cremers and Petajisto (2009); Kacperczyk, Sialm, and
Zheng (2005); Wermers (2010)
5. It is an open research question to
determine the source of these excess returns, that is, what portion is due to
taking positions opposite the Crowd and what portion is due to generating a
superior information mosaic. It is difficult to untangle these two return
drivers, so for now we are left with the plausible supposition that emotionally
driven prices are the most important source of excess returns for fund
managers.
JSK Partners of New York,
LLC
40 Wall Street, 28th Floor
New York, NY 10005
T (212) 537-0462
T (800) 618-1120
F (800) 618-1120
www.jsk-partners.com
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Partners of New York, LLC. Any information presented in this report is
for informational purposes only. All
opinions expressed in this report are subject to change without notice. JSK Partners of New York, LLC have proprietary accounts and funds under
management. These entities may have had in the past or may have in the present
or future long or short positions, or own options on the companies
discussed. In some cases, these
positions may have been established prior to the writing of the particular
report. The above information should not
be construed as a solicitation to buy or sell the securities discussed herein. The publisher of this report cannot verify
the accuracy of this information. The
owners of JSK Partners of New York, LLC and its affiliated companies may also be
conducting trades based on the firm's research ideas. They also may hold positions contrary to the
ideas presented in the research as market conditions may warrant.
