Elliot's Twitter Feed

Subscribe to the RSS Feed:
Compounding the Categories
13f aaron clauset after-tax return alan greenspan alchemy of finance alexander hamilton algo algorithmic trading allan mecham all-time highs alpha alvaro guzman de lazaro mateos amazon amsc anarchy antifragile antti ilmanen apple aqr capital architecture art of stock picking asset quality review asthma atlantic city austerity barry bonds baseball behavioral economics ben bernanke best buy bill maher biotech bitcoin black swan bobby orr bridgewater bruce bueno de mesquita bruce richards bubble buttonwood CAPE capital gains capitalism caravan cash cerberus cfa charles de vaulx charlie munger checklist checklist chicago booth china chord cutting cinecitta claude shannon Clayton Christensen clean energy commodities complex adaptive system compound interest constitution content cord cutting correlation cpi craft beer credit suisse cree cris moore crisis cybersecurity Dan Geer daniel kahneman darwin david doran david laibson david mccullough david wright debt ceiling defense department deficit deleveraging disruptive innovation diversification diversity dixie chicken don johnson economic machine economist edward thorp efficiency efficient market hypothesis elke weber eni enterprise eric sanderson eric schmidt euro european union eurozone Evgeni Malkin evolution facebook fat finger federalist 15 federalist papers ferdinand de lesseps flash crash flashboys forecasting fortune's formula fragility fred wilson gambling gene sequencing general electric genomics geoeye george soros global reserve currency gold gold standard google goose island gore-tex government budget grantham greece gregory berns grid parity guy spier hamiltonian path problem hans harvard business school henry blodgett henry kaufman hft hockey horizon kinetics housing howard marks hudson hudson river hussman iarpa ichiro iex imax implied growth incyte indexation indexing innovation innovator's dilemma internet investment commentary ipad ipo islanders italy j craig venter james gleick jets jim grant jim thome jjohn maynard keynes jk rowling jochen wermuth Joe Peta joel greenblatt john doyle john gilbert john malone john maynard keynes john rundle jonah lehrer juan enriquez justin fox kelly criterion kevin douglas kodak larry david legg mason lehman brothers linkedin liquidity little feat logical fallacies long term capital management louis ck malaria Manhattan manual of ideas marc andreesen marc lasry mark mahaney media mental model Michael Mauboussin millennials minsky mnst moat money mr. market multi-discipline murray stahl myth of the rational market nasdaq: aapl NASDAQ: GOOG nassim taleb natural gas net neutrality netflix new york NGA nicholas barberis Novus oaktree optimality optimization overfitting panama canal pat lafontaine performance personal philip tetlock Pittsburgh Penguins pixar preamble price earnings ratio price to book priceline profit margins prospect theory psychology punditry radioshack random walk ray dalio rebalancing reflexivity regeneron registered investment advisor reproduction value RGA Investment Advisors RGAIA risk risk aversion rob park robert shiller robotics robust ROE s&p 500 samsung santa fe institute satellite scarcity s-curve sectoral balance silk road silvio burlesconi solar space shuttle speculation steve bartman steve jobs stock market stock picking streaming subsidy synthetic genomics systems tax code ted talk the band the general theory the information tomas hertl Trading Bases tungsten twitter undefined van morrison vincent reinhart wall street walter isaacson warren buffet warren buffett william gorgas william poundstone woody johnson wprt yosemite valley youtube

Entries in indexing (2)


Do You Believe in Evolution? (S&P 500 Edition)

With equity markets breaking out to multi-year highs, amidst a persistent spate of negativity, there are all kinds of stories designed to scare people into thinking there is something sinister behind the rally.  Some argue that without Apple, the S&P 500 would be going nowhere, some argue that profit margins are too high and must regress, while others argue that the cyclically adjusted P/E  (CAPE) remains elevated and inconsistent with a longer-term bottom).  All of these arguments have some merit, but none of them measure a key point: today’s S&P 500 is not yesterday’s S&P 500. 

What do I mean by this?  Well quite simply, there is some serious Darwinism going on in the indices, with the outcome being that survival of the fittest has a strong upward bias.  Since the market peaked in October of 2007, exactly 100 companies have been added, and 100 removed from the S&P, with the vast majority of the change having happened during the 2008-09 collapse.  I don’t have the long-term data, but I would surmise a guess that this was the period of the highest turnover in our most prominent benchmark index EVER.  If anyone has the data necessary to confirm this, I would greatly appreciate it.  Regardless, I think it’s safe to say that at the very least, over these last few years we have witnessed one of the largest shakeups in the constituent holdings of the S&P since the Index’s inception.

This is consequential for many reasons.  One particularly important reason, and the inspiration behind my digging into the numbers is the fact that while reading numerous comparisons of the S&P 500 pre and post-2007, not a single analysis I have seen has mentioned or attempted to dig into the composition of the index.  Meanwhile every day I read something that tries to assert Apple is skewing the index.  After looking at the data, it’s become clear that while Apple is a large force, the turnover in the constituent holdings has had a much bigger impact.  Just from the turnover alone, the S&P has been tilted away from financials and old sluggish companies with little to no growth, towards technology and innovative, young companies with rapid expansion.

Out of the 100 companies removed from the S&P 500, 20 were financials that either went bust, were bought out while in distress, or their market caps shrunk so much they were no longer relevant.  Another 7 companies either went bankrupt, or were near bankrupt due to their exposure to the debt crisis, or the rapid disruption of their business model during the crash. 

Here’s a selective list of some notable removals from the S&P 500 since October, 2007 (this list is not comprehensive, but rather just some notable departures):

  • Circuit Cities
  • Ambac Financial Group
  • Countrywide Financial Corp.
  • Federal Home Loan Mortgage Corp (aka Freddie Mac)
  • Federal National Mortgage Association (aka Fannie Mae)
  • Lehman Brothers
  • Washington Mutual
  • Merrill Lynch
  • General Motors
  • CIT Group
  • MBIA
  • KB Home
  • RadioShack
  • Eastman Kodak
  • The New York Times

Some Notable Additions (again, not a comprehensive list):

  • Intuitive Surgical
  • MasterCard
  • Salesforce.com
  • Life Technologies
  • Red Hat
  • Priceline.com
  • Visa
  • Ross Stores
  • Urban Outfitters
  • Berkshire Hathaway
  • TripAdvisor
  • Chipotle
  • Blackrock
  • F5 Networks
  • Netflix

Note how the list of removals is populated with many very old companies, with a heavy concentration of financials and other legacy US businesses that have either gone, are near, or were on the brink of bankruptcy.  Meanwhile, the list of newcomers includes many of the hottest “new” economy companies that are core components of today’s thriving digital age.  Berkshire Hathaway stands out like a sore thumb on the list of newbies, as the company entered the S&P 500 upon completion of its acquisition of Burlington Northern and splitting the “B” shares.  Berkshire “replaced” BNI in the index, thus finally bringing one of America’s largest, most profitable businesses into the composite that is designed to represent American business.  This is a big change, as Berkshire is now one of index’ 10 largest holdings.

This all has a meaningful impact on the intrinsic metrics of the S&P, including earnings, growth, and most importantly, performance.  Priceline is the best performer on the list of newcomers, and it alone is up 779% since the market bottomed in March of 2009.  That is pretty remarkable compared to Lehman Brothers, which only this month “emerged” from bankruptcy as a nearly worthless entity for equity holders.    

Not that these facts alone mean the market should be moving higher, but it is very important to contextualize what we mean when we say “the S&P 500 is making new multi-year highs” and conduct any analysis that relies on index-wide metrics.  Had these changes not transpired, one can reasonably guess that the S&P 500 would be closer to 1,000 than 1,400 today.  And that is a good thing!  Evolution is a powerful, natural force that drives things forward and helps to overcome yesterday’s vulnerabilities.  It is progress, hence it is a more valuable total index.


Is Stock Picking Dead?

In these times of macro-volatility, it’s a line heard more each day: “stock picking is dead.”  The reasons listed are plentiful, but all focus on the increased correlations across the stock market and various asset classes today.  There is certainly an element of truth to the notion that in these volatility storms, everything moves closer together, but the claim that stock picking is dead is not a necessary outcome of the idea that correlations are higher.  There are factors that go beyond just what is happening in today’s market that have led to this misguided conclusion that stock picking is dead, so let’s take a deeper look at what’s behind this financially harmful directive.

Just the other day, Jason Zweig, in his Wall Street Journal column, took a look at whether “index funds are complicating the market,” and if so, what the consequences are.   This is an important conversation, and relates directly to whether stock picking is in fact dead, or not.

Who makes the claim:

There are several different groups behind this claim, and they are important.  In terms of economics, one of the core arguments for the efficient market hypothesis (EMH) is the notion that there is no alpha (outperformance), as prices reflect all known information, and therefore it is nearly impossible to beat the broader indices.  In a rational and efficient world, where information is ubiquitous, why would anyone sell to another with exactly the same information?  Or so the EMHers ask.  

In the stock market, indexers are a direct outgrowth of the EMH. Burton Malkiel’s Random Walk is probably the most visible bridge between the intellectual economics community and actual asset allocators.  Indexers carry out the theoretical consequences of the efficient market theory in buying broad baskets of stocks designed to mirror the performance of the economy at large. 

Next up are the class of speculators that call themselves technical analysts.  There are many kinds of technical analysts, and I use technicals as an important tool myself for timing and scaling into positions, as well as a basic risk management tool.   I do not mean those types of technical analysts.  More particularly, I am speaking of the technicians who use technicals as their one and only metric through which to buy a stock.  Stock picking doesn’t matter to these people, because they believe that charts rule the market and therefore only charts matter.  They buy the best looking lines on charts, and sell the worst, without “picking” a company based on its own intrinsic metrics.  Their intellectual ancestors are Charles Dow and Roger Babson.

Last are the perma-bears.  They believe that correlations are high, because volatility is here to stay as a direct result of some sort of serious global economic malady that will lead to the “end of the economic world” as we know it.  You’ll know these people based on their zealotry for gold as an asset class, complete conviction that they know exactly why everything is going to shit when markets are crashing, and ongoing claims that the market is “inflated, manipulated and rigged” whenever prices are moving higher. To them, everything is on its way to zero, so why bother?

Taking the other side:

The EMHers like to ask what information one person could possibly possess that the other does not, leading to the belief that buying Company A’s stock is worthwhile for oneself, while selling Company A’s stock is worthwhile for the counterparty?  The problem with this question is that there are far more reasons why one type of market participant would sell a stock than just a question about the known information pertaining to the value of a particular business. 

This is a crucial point in why the efficient market theory breaks down.  It only works in an environment when people are buying and selling based on the same information, focusing on the same companies, and thinking about only factors related to the underlying businesses.  There are plenty of people who don’t base their decisions on “information” at all, and are acting based on emotion like sellers in a panic or buyers in a bubble.  There are other examples outside the emotional realm: Indexers, macro-traders, technicians, and short-term speculators.  Importantly, in practice, indexing itself is a major source of company-specific inefficiencies, rather than a factual outgrowth of the EMH.  Legendary value investor, Seth Klarman, has specifically referenced his affinity for investment opportunities that directly arise out of inefficiencies during index rebalancing (Hat tip to Distressed Debt Investing), and this is but one example.

Beyond styles, there are many reasons that people may sell (or buy) stocks that have nothing to do with company-specific beliefs.  This list includes, but is not limited to, young workers’ deposits into 401(k)s, retirees selling savings to live off of, and mutual funds that are forced to sell shares in a spin-off which is worth a price below the fund’s mandated minimum capitalization.  All of the above transactions have nothing to do with what the person inspiring the purchase (or sale) of an equity thinks about that one particular company.  Again, this is important.

Why we have markets in the first place:

While financial headlines swing from "the end of the financial world" to dramatic rescues, it's necessary to take a step back and think about what investing in markets is all about.  Stock picking is precisely it. 

When we look to the essence of the stock market, we realize that it is an arena for companies to sell fractional ownership interests in exchange for the capital necessary to build, grow and/or maintain a business (forget for a second that most IPOs today are to cash out early investors).  This is not a transaction based on the belief that one person is wrong and the other right, nor is it a situation where one person must lose at the other’s expense.  It’s really supposed to be a win/win for the buyer and seller—the buyer gets an ownership stake in a company, and the seller gets the capital they need to deploy in order to increase the value of the buyer’s ownership interest.  At the end of the day, unless people are in markets to invest in companies themselves, then everything else is illusory, and that’s not really the case.

Somehow, the meaning of markets has been so greatly abstracted by the proliferation of types of participants that this existential fact ends up forgotten.   In many ways, it’s thanks to actual inefficiencies in markets that people learned ways beyond just investing in businesses in order to make substantial sums of money in capital markets.  This is why they say that “stock picking” aka investing in companies is dead.

Pulling it All Together:

These other strategies have made money for periods of time, but the most consistent through all time periods is investing in strong businesses for the long-term.  This is not to discount the efficacy and importance of other types of analysis.  In some ways, it is the generalist who is most adequately equipped for long-term investment, for knowledge of macroeconomics, technicals, etc. are invaluable tools for an actual company-specific investor.  It’s important for any kind of investor to understand who the market participants are, and why happenings play out as they do.  Use these other strategies as tools to maximize the returns from investing in really solid long-term businesses, not as ends in and of themselves. 

In 2010, I conducted an interview of Justin Fox (now the editorial director of the Harvard Business Review Group) shortly after he wrote The Myth of the Rational Market, a comprehensive review of the history of the competing types of investment theories and how they came together to form competing bases of economic theory.  Fox concludes that Benjamin Graham-style value investing is the only conssitent strategy through all time, but asserts that t is psychologically draining to consistently instill a sense of discipline on oneself, and therefore people tend to float dangerously towards alternatives. The book is an excellent read that traces the history of investing and economics from Irving Fisher to Benjamin Graham to Eugene Fama all the way through the physics-drive Santa Institute.  In my interview with Fox, we had the following exchange that I think very aptly sums up the problem with the question "is stock picking dead" and why the answer is conclusively no:

Elliot: Now, correct me if I’m wrong but one of the concepts that I took to be a semi-conclusion in “The Myth of the Rational Market” was the idea that the Benjamin Graham model of value investing has withstood the test of time, that people who are able to take the information and come up with what they think is a fair value and have the ability to ignore what “Mr. Market” is telling them on a daily basis have an edge over time.  Do you think that’s a valid interpretation?

Justin: Absolutely – I completely think that’s true.  And I think one of the interesting things that is sort of common sense, but that finance scholars have finally started studying and recognizing, is that one of the big reasons for why it’s really hard for a professional investor to stick it out as a value investor is that it requires being unfashionable and going against the crowd.  And unless you’ve either built up this incredible reputation—although even that doesn’t really help you that much in investing as people forget your reputation and a year or two if you fail to beat the market—or you get a situation like Berkshire Hathaway where it’s actually not the investors’ discretionary money that you’re investing, but the cash flow from Berkshire.  There’s really no way anybody can discipline Buffett except over maybe a really long period that gives you the freedom to do it.

The flip side of that is that as an investor you have a situation where there’s such little control over the investment decisions.  That’s the difficult situation that our investors fear. There’s a reason why people invest in mutual funds.  They like the flexibility of being able to take their money out.  But the very fact that they do that, and that if you’re some value fund and it’s 1999, everybody wants to take their money out of your fund regardless of your own performance; that’s exactly why it’s hard to be a value investor, and a good economic reason for why value investing works.  Beyond that is the individual as a value investor.  Obviously, you don’t have to worry about customers but you just need a pretty strong constitution and maybe a different psychological wiring than most people to be able to stick that out.