Words of Wisdom On The Pursuit Of Holy Grail Investing

``Whatever method you use to pick stocks or stock mutual funds, your ultimate success or failure will depend on your ability to ignore the worries of the world long enough to allow your investments to succeed. It isn't the head, but the stomach that determines the fate of the stock-picker." - Peter Lynch

In stock markets, the implication that the public buys stocks because of entirely valuation purpose is a fallacy.

People buy or sell stocks for myriad of reasons, aside from valuations, namely, monetary policy induced responses (yield chasing), momentum, charting, punting or even to the most trivial reasons such as social pressures, gossip based or ‘my neighbor/TV/guru says so’ and etc.

Valuations, as presented by typical sell side institutions, frequently represents as fodder for cognitive biases for participants in search of a fillip or stimulant to take or justify actions (confirmation, available or information bias) or ownership (post purchase rationalization).

It’s almost commonplace to see people act (buy) supposedly based on “fundamentals” and act (sell) oppositely based on intuition. Time would, in essence, be the defining or distinguishing factor, as short term trades HARDLY REFLECT on the changes in the so called “micro” or “macro” fundamentals which are mostly long term driven.

Hence, rationalizations over the direction of actions don’t match and serve as concrete evidence of cognitive dissonance or disorientation on the part of the short term punter.

In an off track horse betting station, these would be the routine responses when a punter loses a bet… “I had that horse on my list, but”, “I was about to bet on that horse, but”, the “teller changed the number”, the “jockey took a dive!”, the “race was rigged!” and etc…

For the winner, I am GOOD!!!

This practically is a feel good thing or about self importance, more than risk-reward tradeoffs over the odds of the racing event as horse punters essentially disregard the cumulative effects (ratio of losses over wins) and look at day to day outcomes.

In behavioral finance lingo this is called fundamental attribution error or the attribution of success to oneself and failures to external or other sources.

The same errors can be observed with most market participants with short term expectations and perspectives.

And that’s why short term perspectives seem almost always in search of the ever elusive Holy Grail, because goals, required information, emotions of the moment and actions don’t square.

And Dr Janice Dorn, in her magnificent article Trading Lessons: There Is No Magic Bullet published at the minyanville.com, eloquently articulates on the psychological framework behind these (bold highlights mine),

``Most traders are looking for the Holy Grail, the keys to the kingdom, the one great book. They want the magic indicator, the chart pattern, thing, or person that will tell them what's going to happen, and what to do.

``It's a natural human tendency to want to know what's going to happen next. Chart patterns, indicators, fundamental analyses, or technical analyses are constructs we build in an attempt to bring order to uncertainty. We do this in part because we're afraid that, without a detailed roadmap, we may have no future.

``In the process of building these models, we become them. We want to believe what our eyes are seeing, when what we're really seeing are our own limitations. Charts are emotions plotted on a grid: When emotions change, the charts do, too. We can't control that, just as we can't control what others believe, or how they act on their beliefs.

``We can control only one thing: how we respond to the situation that's right in front of us. In order to do this with consistent success, we must adopt an attitude of flexibility, and rid ourselves of all our rigid assumptions.

``In the final analysis, those things we've seen on paper or had in our heads before we enter the markets are illusions. They may be useful illusions, but they're illusions nonetheless. We have no idea whether they're true or not until the markets tell us. If there's any absolute truth in trading, it's that, with 2 possible exceptions, the markets are always right. Traders ignore this at their own peril. If there's a technique for winning, it's to stop believing in so many things that are wrong. In order to do this, we must learn to harness the villains of pride and greed that speak falsely to us, telling us that we've already won. We haven't won if the markets say we've lost. By eliminating what's false, we open ourselves to the truth.”

In short, biases are illusions and pride and greed are obstruction to goals, which ultimately reveals that the basic problem, in the financial markets, is in dealing with the self. Ergo, any serious traders or investors would need to subdue or minimize these frailties and develop a strong sense of self discipline instead of looking for external attributions or excuses.

This goes similar to the prescriptions of Peter Lynch of the traits of a successful investor, ``The list of qualities [an investor ought to have] include patience, self-reliance, common sense, a tolerance for pain, open-mindedness, detachment, persistence, humility, flexibility, a willingness to do independent research, an equal willingness to admit mistakes, and the ability to ignore general panic.”

Since the world is highly complex, where we can’t discount the contribution of luck in any endeavor we opt to undertake, I’d like to add, the ability to harness and manage luck!

The Asian-Emerging Market Momentous Historical Bubble?

``When a long-term trend loses momentum, short-term volatility tends to rise, it is easy to see why that should be so: the trend-following crowd is disoriented.”- George Soros

Excess volatility is the name of today’s game.

Global equity markets have been in a wild rollercoaster ride of late.

While US and European markets continue to sag following last week’s sharp decline, many of key Asian markets rallied hard recovering substantial segments of losses from the previous week.

So we seem to be witnessing another round of divergences at play, see figure 2.

Figure 2: stockcharts.com: Asia and EM stocks OUTPERFORM anew

The Dow Jones Asian Index which includes Japan appears to be testing for a new high, along with the less robust Emerging Market index (EEM) and the US S&P 500 (SPX). The weakest link seems to be European Stocks (STOXX).

Momentous Historical Bubble, Elixir Trade Model

The same friend, who commented earlier about the temptations of falling captive to gravity pulled “knives” in a bearmarket, likewise remarked of his friend who earlier paid for a series of monthly subscriptions to a local analyst, who is on the business of issuing regular technical charting outlook.

His friend came to realize that chart reading can be variable, vacillating and couldn’t be relied on, and hence, after a few months desisted from extending this “privilege”.

It’s simply amazing how people can be so captivated or bedazzled by the allure of short horizon Holy Grail type of market approaches, such that they have been shelling out substantial amounts to pay for guidance that dwell mostly on momentum driven or support-resistance trades or simply confirming biases of market participants through the technical picture. It seems like an incredible business model, I might add.

Yes, although this has been an opportunity cost for me in terms of the newsletter business paradigm, nonetheless, we’d rather stick by our principles to deal with prudent investing.

So aside from illustrating the possible dynamics of how the retail market works and how the some local subscription model business had profited immensely from the need for elixir based trades, the point of this article is to prove that today’s market can truly confound mechanical technicians or even macroeconomic fundamentalists.

Why is this so?

To put on our Ivory Tower thinking cap, we quote Prof. Steve Horwitz in The Microeconomic Foundations of Macroeconomic Disorder: An Austrian Perspective on the Great Recession of 2008, ``The Austrian approach to macroeconomics can already be seen as being fundamentally microeconomic. What matters for growth is the degree to which microeconomic intertemporal coordination is achieved by producers using price signals, especially the interest rate, to coordinate their production plans with the preferences of consumers. However, this coordination process can be undermined through economy-wide events that might well be called “macroeconomic.” In particular, the very universality of money that makes possible the coordination that characterizes the market process can also be the source of severe discoordination. If there is something wrong with money, the fact that it touches everything in the economy will ensure that systemic “macroeconomic” problems will result. When money is in excess or deficient supply, interest rates lose their connection to people’s underlying time preferences and individual prices become less accurate reflectors of the underlying variables of tastes, technology, and resources. Monetary disequilibria undermine the communicative functions of prices and interest rates and hamper the learning processes that comprise the market.” (emphasis added)

In short, too much of monetary inflation distorts the function of price signals which essentially increases speculative activities, massively misallocates capital away from consumer preferences and engenders excessive market volatility.

And if we go by the market savant George Soros’ perspective of the market, ``Many momentous historical developments occur without the participants fully realizing what is happening.”

Incidentally we’ll be quoting much of George Soros’ market wisdom for this article.

And such “momentous historical development” could essentially be a seminal formation of the next bubble, in Asia and in Emerging Markets, see figure 3.

Figure 3 US Global Investors: Excess Liquidity Drives Up Asian Markets

According to the US Global Funds, ``U.S. Federal Reserve’s reluctance to withdraw from quantitative easing programs should bode well for Asian asset prices going forward. The past 25 years suggest that when money supply expansion outpaced GDP growth in the U.S., excess liquidity would typically drive equity prices higher the following two years in emerging Asia.” (bold emphasis added)

Oops, let me repeat… “excess liquidity would typically drive equity prices higher the following two years in emerging Asia”!!!

We are hardly into the first year of liquidity driven boom, which subsequently means more upside ahead.

So while markets can go anywhere over the interim, and that infirmities may follow the recent strength due to numerous variables: such as technical corrective patterns in the US [see INO's Adam Hewison On The S&P 500: Market Tenor Has Changed, Emphasis On The Negative-this is assuming the Phisix will track the US] or in the Phisix itself, seasonality weakness (July to September statistically is the weakest quarter for stocks), volatility brought about by next wave of US mortgage resets [see US Financial Crisis: It Ain’t Over Until The Fat Lady Sings!] and plain vanilla momentum- the sheer might of the combined stimulus package from Emerging Markets, (see figure 4) aside from those applied in OECD economies, could translate to an awesome impact for the markets in Asia and the Emerging markets to behold.

Figure 4: Deutsche Bank: EM-Anti Crisis Measures

The Philippines relative to other Emerging Market contemporaries seems hardly one of the most lavish spenders for government stimulus. Think about it, if deficit spending equates to weak currencies as discussed last week in Philippine Peso: Interesting Times Indeed, then it follows that China, Russia, Hong Kong, Brazil, South Africa, Vietnam, Thailand would all have weak currencies relative to the US dollar due to their larger deficit spending. Unfortunately this hasn’t been the case.

Nonetheless, ``Asian and Latin American banks, notes the Deutsche Bank, “seem to have learnt from their past crisis episodes. In general, they have restricted foreign-currency exposures and funded credit expansion with domestic deposits. Thus, most banking systems have suffered from tighter liquidity conditions but only a few have needed recapitalisation (Korea, India and Hong Kong). On the fiscal side, government packages seek to neutralise the effect of shrinking domestic demand as well as supporting local companies unable to roll over their foreign debt obligations.” (emphasis added)

As we have long been saying, an unimpaired banking system in the region and in Emerging markets coupled with substantial savings has the potential to take up the credit slack from the bubble bust plagued OECD economies to shore up domestic demand. And this alone is a massive force to reckon with.

Another empirical example, just this week, it’s like I received numerous calls or text messages from different banks on daily basis, offering me bank loans mostly based on the unused portion of my credit cards. I’d assume that this applies to their entire customer base.

As the Deutsche Bank concludes, ``The crisis is not over yet and we do not rule out additional bumps in the road. However, it is fair to state that in a more globalised world characterised by stronger linkages among economies, emerging markets are proving to be better prepared to face external shocks than in the past.”

Well “proving to be better prepared to face external shocks than in the past”, can be interpreted in a relative sense and applicable only when compared today against the recent past.

But if the bubble cycle is brewing from within, then such conclusion won’t hold when the bubble pops.

Inflation Analytics Over Technical And Fundamental Approach

Remember in a highly globalized world, the transmission mechanism from inflationary policies could be very substantial and has far reaching consequences.

And that is why in spite of the most recent global meltdown, out of the 77 countries monitored by Bespoke Investments [see our earlier article Inflation or Deflation? The Global Perspective], 59 nations experienced consumer price inflation against 14 nations that saw consumer price declines (consumer price deflation) while 4 nations saw flat CPI rates. This translates to a ratio of 4:1 in favor of inflation with an average inflation rate at 4%! And that includes the peak of the meltdown!

For all the claptrap about the global deflation bogeyman, this should have disproved such an assertion.

Figure 5: Danske Weekly Focus: The tide is turning

And the credit boom appears to be filtering into the real economy as Industrial production in key Asian regions has sharply picked up, shown in Figure 5.

Nonetheless, aside from disoriented chart technicians, we also have conflicting predictions from multilateral agencies.

The readjusted outlooks saw the World Bank projecting a downgrade, whereas the IMF has raised its forecasts for world economic growth. On the other hand, OECD has joined IMF to forecast a modest increase in global growth.

2 out of 3 doesn’t mean that the majority is right.

Nonetheless, to put this anew in the context of George Soros’ reflexivity, `` The greater the uncertainty, the more people are influenced by the market trends; and the greater the influence of trend following speculation, the more uncertain the situation becomes.”

So yes, more reflexive actions are unfolding in the marketplace. As the market prices continue to move higher, the public will likely interpret market performance as indicative of the real economy.

Again from Mr. Soros, ``People are groping to anticipate the future with the help of whatever guideposts they can establish. The outcome tends to diverge from expectations, leading to constantly changing expectations and constantly changing outcomes. The process is reflexive.”

So not only do we speak of excess liquidity, but of excess liquidity translated into a secular weak dollar trend see Figure 6.

Figure 6: US Global Investors: Inverse Correlation Weak US Dollar, Strong Asian Markets vice versa

The weak dollar has had a strong inverse correlation with the performance of Asian stock markets, where a strong US dollar trend translates to weak equity markets and weak US dollar equals strong Asian markets trends.

With the US dollar trade weighted index expected to suffer from a secular decline as a consequence to its massive deficit spending, the continuity of these correlation suggests of the persistence of a revitalized or reenergized Asian markets.

Moreover, the prospective weaknesses in the respective bubble bust scourged economies combined with the appearances of the “right” and “effective” remedy measures ensures that present policy directions will be sustained.

Proof?

The ECB recently announced that it will be lending a historic €442 billion ($621 billion) over the next 12 months to backstop liquidity within the region.

The US Federal Reserves’ FOMC meeting recently announced that it would be extending most of its liquidity facility programs specifically, the Board of Governors approved an extension to 1 February 2010 of the following: Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility (AMLF), Commercial Paper Funding Facility (CPFF), Primary Dealer Credit Facility (PDCF) Term Securities Lending Facility (TSLF).

The expiration date for the Term Asset-Backed Securities Loan Facility (TALF) remains set at December 31, 2009. The Term Auction Facility (TAF) does not have a fixed expiration date. In addition, the temporary reciprocal currency arrangements (swap lines) between the Federal Reserve and other central banks have been extended to February 1. (Danske Bank)

The Swiss National Bank conducted a series of intervention in the currency markets last week to keep the Franc from rising amidst a deflationary environment and shrinking economic growth (WSJ).

And this hasn’t been confined to the Swiss Franc, market chatters speculated on possible government interventions in the currency market in the Kiwi (New Zealand Dollar), the Loonie (Canadian Dollar) and the Aussie (Australian Dollar). (Bloomberg)

Moreover, the issuance of the new Won 50,000 banknotes in South Korea, after 35 years (the largest had been Won 10,000), further fueled speculations that the South Korean government could be expecting higher inflation from current policies undertaken (Financial Times).

As you can see, global governments have been conducting mercantilist “race to bottom” policies for their respective currencies to maintain their “export” latitude.

And as Steve Horwitz, echoing the Austrian school perspective, says that, ``If there is something wrong with money, the fact that it touches everything in the economy will ensure that systemic “macroeconomic” problems will result.”

And the continuation of these developments will only compound on the growing risks of a global inflation crisis.

So in my view, globally coordinated policy based programs to ensure excess liquidity through zero bound rates, quantitative easing and intensive stimulus fiscal spending programs, which has been manifested in the steepening of the global yield curve [see Steepening Global Yield Curve Reflects Thriving Bubble Cycle], a floundering US dollar, currency interventions or the implicit currency war, the reflexive market action which has been diffusing into the real economy and rising risk appetites based on credit boom outside the bubble plagued economies- all conspire to pose as more powerful or potent forces to deal with than simply technical or seasonal factors over the next “two years” at least.

Since market timing isn’t likely to be anyone’s expertise especially in the context of short term trades, we’d rather focus on the major trend as defined by George Soros.

The Boom Bust Cycle Of George Soros

This brings us to the boom bust stage cycle as defined by George Soros which we last mentioned in 2006:

1) The unrecognized trend,

2) The beginning of a self-reinforcing process,

3) The successful test,

4) The growing conviction, resulting in a widening divergence between reality and expectations,

5) The flaw in perceptions,

6) The climax and finally

7) A self-reinforcing process in the opposite direction.

In my assessment, present developments are highly indicative of the transition from 1) the unrecognized trend-as manifested by the substantial skepticism over the present market cycle and 2) the beginning of a self-reinforcing process.

In other words, the bubble cycle has much to accomplish yet.

Since this article has been a George Soros quotefest, the last statement belongs to Mr. Soros, ``Economic history is a never-ending series of episodes based on falsehood and lies, not truths. It represents the path to big money. The object is to recognize the trend whose premise is false, ride that trend, and step off before it is discredited"