Stock Market Investing and Financial Sorcery

``We are all faced with a series of great opportunities brilliantly disguised as impossible situations."- Charles R. Swindoll, American Writer and Clergyman

To some the notion of the role of analysts or money managers is a job similar to the practice of sorcery, where we try to divine the future with tarot cards, mystical spells and arcane rituals or to its financial equivalent-with Greek ‘secret’ formulas or complex math algorithmic models or that what we say or write about should happen instantaneously or that our role is to know entirely the causalities of the marketplace, or identify market tops and bottoms, all of which should be translated to “alphas” or outperformances in our stock selection. In short, the expectations of supernatural power of clairvoyance applied to stock selection.

For me, this signifies the problem of a risk reward outlook based on cognitive biases of anchoring and the availability bias, where anchoring or focalism is a cognitive bias which describes the common human tendency to rely too heavily, or "anchor," on one trait or piece of information when making decisions (wikepedia.org). A basic example is when one reads or gives too much weight into the recent markets activities (declines or losses) as an eternal trend, without considering the phases of market cycles. (If you think the Phisix will return to 1,000 then go ahead and sell.)

On the other hand, availability bias is a human cognitive bias that causes us to overestimate probabilities of events associated with memorable or vivid occurrences. Because memorable events are further magnified by coverage in the media, the bias is compounded on the society level (wisegeek). Example, when we read the cumulative negative gloomy headlines (from politics, rice crisis and rising prospects of a US recession) coupled with signs of declining markets then the probable tendency for impulse driven participants is to flee from the financial markets on the expectations of more bad news that would further drive down equity prices.

So a combination of “anchoring” into today’s market performances compounded by media generated fears or the “availability bias” may lead to an overestimation of risks while at the same time underestimating rewards.

Well if we apply this to the US; its markets have been plagued with a litany of dreadful news, events and developments-such as tightening lending standards, rising incidences of foreclosures and bankruptcies, falling housing prices, increasing costs of financing, retrenching consumers, diminishing trend in corporate earnings, repeated bout of seizures in the credit markets, soaring commodity prices, accelerating consumer prices-yet its major benchmarks have still been trading sideways instead of a “collapse” so far.

This has been defying the predictions of well oiled articulate arguments of bearish analysts. (Yes, admittedly my risk bias is tilted on such outlook, thus the aura of cautious investing).

But can the bears be right? Of course, but risk management depends on how one allocates his portfolio and the risk instrument used under the prevailing market cycle.

The Difference of the Analysis of Market Cycles From Stock Selection

We had been lucky enough to have predicted the rise of the Phisix in 2002, the renascence of the Philippine Mining industry in 2003, the Peso’s reversal in 2004, the US housing bust in 2006, the rise of soft commodity prices or Agriculture commodities to even the Phisix bear market in early August (see Phisix: Undergoing A Cyclical Bear Market Within A Secular Bull Market Cycle?). Therefore much of the major cycles were firmly under our grasp.

Of course I had some blips too. For instance, I even got teased for “panicking” out of the market at the first sign of a meltdown in July when the market sharply recovered into October. Obviously from the privilege of the hindsight, October proved to be a classic Bull trap which basically validated our July-August view. Unfortunately “pressures” to participate in rallies compelled some risks positions, which have now been adversely affected by the recent declines. The good news is that some segment of cash which had been raised during the initial selling was kept as insurance against adversity and now serves as buffers for opportunities.

Yet as you can see, reading market cycles is starkly distinct from stock selection.

Remember stock market investing is a complex task. The financial marketplace is basically a collective psychology of thousands of participants whose decisions are weighed by diverse variables…in the stock market-from mere emotions, tips from friends or brokers to syndicated moves by stock market operators to calculated engagements by institutions. Thus, the attempt to read the minds of these participants is the equivalent practice of financial sorcery.

If a stock/s does not reflect the performances of any representative benchmark such does not imply that it is always blessed or condemned to either outperform/underperform forever. Remember, reading past performances into the future is never a guaranteed outcome. While history may have some guidance, they may occasionally diverge.

In addition, while the performances of stock markets here or elsewhere are driven by its own cycle, this is not a simple task because stock market cycles are underpinned further by the intricate interplay of a host of other cycles (psychological, economic, business, credit etc…).

That is why I pay heed to Mr. Edwin Lefèvre’s a.k.a. Jesse Livermore quote as my stockmarket meme (highlight mine),

``I never hesitate to tell a man that I am bullish or bearish. But I do not tell people to buy or sell any particular stock. In a bear market all stocks go down and in a bull market they go up...I speak in a general sense. But the average man doesn’t wish to be told that it is a bull or bear market. What he desires is to be told specifically which particular stock to buy or sell. He wants to get something for nothing. He does not wish to work. He does not even wish to have to think. It is too much bother to have to count the money that he picks up from the ground.”

Mr. Livermore implies that performances of individual stocks depend on the whereabouts of the general stock market cycle. How true this is? Today, under this interim bear market cycle, we can name only a handful of stocks still trading at the near peak (of not less than 20% decline). So his assertions are more valid in general than otherwise.

Moreover, individual stocks are likely to perform under their own distinct functionalities given the above premise- it could be driven by mere emotions, corporate developments or fundamentals, insider activities, technical or by a consortium of stock operators or by anything else.

In other words, attempts to identify all these short term variables consistently are beyond my or anybody’s ken. It is nearly an impossible task.

All we know is that especially applied to the Philippines, whose market is way underdeveloped, when the stock market is bullish people conjure up all sorts of (mostly invalid) reasons to participate in rising stocks regardless of risks. This applies inversely to falling markets. Thus, expectations to predict which stock issue would move next, or would serve as the next “favorite”, or attempting to time markets for tops and bottoms is a futile exercise equivalent to financial sorcery.

Again from the legendary trader Jesse Livermore ``It never was my thinking that made the big money for me. It always was my sitting. Got that? My sitting tight. Men who can both be right and sit tight are uncommon. The market does not beat them. They beat themselves, because though they have brains they cannot sit tight."

Bottom Line: We are NOT in the practice of financial sorcery. We cannot identify the next crowd favorites. We invest out of risk reward tradeoff concerns, where present declines appear NOT to entail a reversal of the long term trend but instead reflects on the interim countercyclical trend amidst a secular bullish trend until proven wrong. Nonetheless, we are NOT impervious to mistakes or losses as risk taking is NOT about perfection or the ability to predict winners consistently but one of reducing risk and optimizing gains. We must remember that since markets operate on cycles, no trend goes in a straight line. Impatience guarantees underperformance.

Finally, the major force of ANY asset boom-bust cycles is rampant speculation driven by excessive monetary inflation and massive credit expansion. There are not enough indications of such excesses permeating into the domestic stock market or to the domestic economy. Not yet anyway. Moreover, such stimulus have not driven the stock market levels to euphoric stages or equally have not yet posed as systemic risks to the economy. Therefore, the present decline is unlikely a long term trend reversal.

Given the present environment of fear, as our favorite icon, Warren Buffett once said ``Great investment opportunities come around when excellent companies are surrounded by unusual circumstances that cause the stock to be misappraised."