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Thursday 6 September 2012

The Zeitgeist Investor: Wheels, Arrows and Buggy-Whips

This is an additional chapter to The Zeitgeist Investor, available at a good eBookshop near you.

So, although we’ve seen the effect of cycles on markets and on investor behaviour, and of investor behaviour on markets and cycles, it isn’t truly clear that those cycles are really cyclical.  If you look at a long-term chart of any major market then you don’t see an up and down wavy pattern but a more or less continuous upward trend.  This looks less like a sine wave and more like time’s arrow.

Take, for instance, the great flash crash of Black Friday in 1987.  As we’ve seen, this was underpinned by a whole range of factors, including new technology, an unthinking reliance on efficient markets theory and kneejerk reactions by investors.  It was a big, big thing at the time.  Look at the long term charts, though, and all you see is a tiny bump in the upward trend.  Look further back at the events of 1929 and 1931, that so undermined Irving Fisher and conditioned Ben Graham, and their long-term financial impact is vanishingly small.  The problem is about scaling, and the problem is about investor overreactions to very near-term events.

In the short-term you’ll frequently find commentators arguing that markets and securities will tend to mean revert.  So, for instance, corporate earnings will oscillate around a common level, and this level doesn’t vary much over history.  So if we find earnings are running at above their average levels we can be reasonably sure that eventually they’ll revert back at some point: and when this happens stock prices will probably fall, although because sometimes people get overexcited this often doesn’t happen immediately; the longer-term implications can take a while to sink in (See: Value in Mean Reversion).

Yet although earnings in the short-term may mean revert, in the long-term the general economy doesn’t, or at least it hasn’t for the past two hundred years.  What it’s done has grown, and grown, and then grown some more.  And, as it’s grown, corporations and stockmarkets have grown with it, such that fluctuating levels of profitability and stock prices disappear into the noise.  This growth masks a lot of changes, of course.  At the end of the nineteenth century the world’s biggest corporation was the Egyptian Suez Canal Company; the majority of the original members of the Dow don’t exist in their original form anymore (see: Moats, Unbundled).  Markets have grown, but their internal structure has changed significantly as this has happened.  Innovation drives growth, but blows up previously sensible business models.

Seen through the wrong end of the telescope, then, all the discussion about cycles and mean reversion is really an error caused by our myopic tendency to focus on the short-term.  It’s salience again, as we’re conditioned to react to news in our local environment, and fail to take the longer-term view.  In fact, if you’re a professional in the securities industry you should have no interest in the long term, because the long term doesn’t generate revenues, bonuses and commissions – so you should really expect that analysts and brokers will find reasons for you to trade, because they need reasons to trade themselves; and this is true no matter how good they are.

This, you might think, leaves us in a bit of a quandary – if markets do go through shortish-term cycles but will tend upwards over longer periods should you focus on the short-term or the long?  The answer, roughly, is that it depends.  There’s nothing inherently wrong in making money in the short-term, but it’s very difficult to do.  You need the iron discipline of a Ben Graham to be successful at that.  In the longer term it’s probably a bit easier – you need a decent portfolio of stocks and you need to make sure that you’re not backing buggy-whip manufacturers.

The buggy-whip syndrome is the name given to the tendency of value investors to focus solely on the fundamentals of stocks and to fail to look at the bigger picture.  At the end of the nineteenth century the value of buggy-whip manufacturers crashed and if you were looking for mean reversion then they were a prime candidate.  The only trouble is that we’re still waiting.  Horseless carriages were innovated out of existence and the desperate entreaties of the buggy-whip makers to mandate car whipping was a forlorn and desperate last throw of the dice.  And very typical, incidentally, of outmoded industries: wig makers tried something similar a century before with attempts to legislate mandatory wig wearing by men.  Had these attempts been successful most British men would be walking around looking more like extras in an S&M movie than they already do.

Basically it didn’t matter over what timeframe you invested in buggy-whipping or wig-wearing, it was never going to be enough.  Similarly today we can see that the internet is destroying the business cases behind a whole host of industries, and it’s hard to take a long-term view on the future success of specialised retailers or publishers.  So even long-term investors need to think hard about their investments, and in the short-term, what look like cheap stocks may end up as so-called value traps – stocks that never regain their former glories.

In all of this, though, note that “short-term” is still a couple of years, minimum.  Two years is roughly about the amount of time it takes the average stock to recover from some nasty, value eroding event, which is roughly why Ben Graham had that as his maximum holding period.  Operating at anything less than this is a mug’s game: the evidence that day traders lose money is overwhelming, see How Much Do Individual Investors Lose By Trading, for instance, and this isn’t surprising when you look at the resources available to the institutions that dominate the securities industry.

It’s not just that they can employ the best brains, but that they can invest in dizzyingly efficient technology.  Take just two financial innovations – dark pools and algorithmic trading.  In dark pools (see Dark Pools and Adverse Selection) the institutions trade amongst themselves, off-market, using the public prices of stocks as a price setting mechanism.  Institutions can trade stocks invisibly and cheaply without anyone knowing, a parasitic relationship if there ever was one.

Algorithmic trading (see: Rise of the Machines) is computer based investment, where the algorithms buy and sell without a person in sight, often faster than you can click your fingers.  By encoding every known anomaly and psychological quirk they can exploit any market mispricing far, far faster than a private investor can.  Institutions invest billions in this type of technology, even aiming to geographically site their computers where they can gain a nanosecond advantage over their competitors.  It’s the archetypical picking up pennies in front of the steamroller business model.

As seen with the woes of Knight Capital, which in 2012 managed to lose $400 million in a matter of minutes when its software went wrong (see: Knight, Knight, Automated Trading Dreams), these innovations can occasionally cause the markets to go haywire.  These types of flash crashes won’t help the short-term trader, who’ll tend to go with the momentum and sell (or buy) at just the wrong time.  Given the weight of technology and funds lined up against them short-term private investors have very little chance of any skill based outperformance. 

So the wheel of mean reversion in the short-term needs to be handled carefully, and the arrow of economic growth in the long-term needs to be balanced against technology changes which have the power to eliminate whole industries and to radically change the profitability of others.  And perhaps the biggest of these technology changes to consider, going forward, is in energy. 

Prior to the eighteenth century economic growth, as far as we can tell, had been pretty much zero for all of history. Then, sometime around 1800, economic growth exploded and has been rocketing skywards ever since.  There are lots of theories about why this happened, but one definite factor was that we figured out how to replace the horse with horsepower: our development of technologies to extract and exploit fossil fuels has been key to the upward trend in markets and economies (see: An Age of Miracles and Wonders).

Now, if the arrow of economic growth was driven by our ability to access cheap sources of energy then one thing that might cause a mean reversion of the whole market would be the end of the era of fossil fuel dependence.  This problem, known as Peak Oil, the point at which we have exhausted more than half the world’s easily accessible oil reserves, is probably upon us (see: Peak Oil, The Revenge of Planet Earth).  Even if it isn’t it will be one day, and that day is likely not a long way away.  This doesn’t mean that we’re destined to see a collapse in the world’s economy – we have the knowledge and technology to find renewable sources of energy and to reduce our overall energy consumption.  But it is a risk, and we shouldn’t be entirely blind to the possibility that the ever-upward arrow of economies may simply be the long climb up one side of a mountain, rather than a never-ending stairway to heaven.

The other side of fossil fuel use has been environmental destruction.  Most experts, even many who were previously sceptics, now accept that human activity is causing the planet to warm, and that this is going to have environmental effects that are difficult to predict, but which aren’t likely to make the global island we live on easier to survive on.  It’s another open issue as to whether we can maintain our history of economic growth in the face of planetary warming.

There are other threats to the economic arrow of growth: the rise of developing nations and growth of the global population is placing unprecedented pressures on the Earth’s ability to feed and protect its people. Meanwhile the aging demographic of developed nations suggests that the baton of growth is likely to pass to these emerging economies.  Risks are everywhere, but this is nothing new, it’s simply the zeitgeist of our times.  These are the trends that a Zeitgeist Investor should be looking to exploit, as we try to navigate our way through the short-term towards the long-term: recognising that both the short-term cycle of the economic wheel of fortune and the long-term arrow of economic growth are true.  You simply have to pick where you want to place yourself on this continuum of possibilities.

Of course, if things really go wrong then the Earth will turn into a raging inferno incapable of supporting life.  But, to be honest, if that happens we’ll probably have worse things to worry over than the performance of our stock portfolios.  It’s all a matter of scale you see.

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  1. I recently saw a TED talk that touched on some of the ways that love and money management suffer from similar cognitive biases - cool stuff! Keep up the good work....

  2. Hi Timarr,
    I think you need to re-set your chart to log scale.
    The crashes of 29-32, 73-4 were not small at all--they were massive.
    87 was more of a blip but again, not for those who went in during the summer of that year and lost their nerve in the autumn. And that's many.

  3. Hi Paul

    Well, if you invested in 1929 or 1973 and sold in 1999 it wasn't a bad call :)

    But, of course, you're right in general. The point is really that timing only matters when you get it badly wrong, that there aren't many points at which that happens and that they're usually characterised by extreme levels of risk seeking.