A conversation in the hotel lobby…
Woman — tall, thin, attractive:
‘Hey, you must be a writer. You look like a writer.’
Your editor, hunched over his laptop writing…
Woman, putting her arm around his shoulders…
‘I’m Rebecca. What’s your name?’
‘What are you writing about?’
‘A subject so boring I wanna slit my wrists every day.’
‘Well, what are you doing?’
‘We’re here with a group of Fortune 500 business executives. We’re consultants. The companies hire us to help their employees find innovative solutions to their problems.’
‘What kind of problems?’
‘All kinds…they each have their own problems…but we don’t get into that. We just show them that whatever their challenge is, the solution is within themselves.’
‘How do you do that?’
‘Well, they meet here. They each get a backpack. In the backpack are the things they need for problem solving. We give them a map and directions to places all over town where we have meetings.
‘The idea is to get them out of their routine. Out of the box. They will have some totally new experiences…and some challenges that have nothing to do with their daily work.
‘This may sound funny…but we open their minds to new thoughts. In the summer, for instance, we encourage them to eat a peach and let the juice trickle down their chins…’
‘I don’t know if I would dare to eat a peach, if you know what I mean…’
‘Sounds crazy, I know. But it is the realization that they don’t have to always do everything the way they’re ‘supposed’ to do it…that there are other ways…that is what opens them up to thinking differently and solving their problems.’
We turned back to our writing…confident that the world still turns…and still finds new and imaginative ways to separate people from their money.
Now, let us take up the subject of macroeconomics…
You send it off to do a job; you’ve got to know the territory.
And as it turns out, context is more important in investing than in just about everything else. You can find a good house or a good wife in a bad neighbourhood. But it’s almost impossible to make money when ‘the market’ is bad.
Broadly speaking, there are two sources of investment gains: alpha and beta.
Beta is what you get from being ‘in the market’.
Say you buy a handful of stocks at random. Then the stock market goes up. Chances are, your stocks will go up too.
Alpha is what you get by outperforming your fellow investors. If the average stock goes up 10%, and your stocks go up 20% on average, you’ve got positive alpha.
The trouble is alpha is hard to get. And it’s even harder to get consistently.
Investing is competitive. To get positive alpha (above-average performance) someone else has to get negative alpha (below-average performance).
We’ll discuss this more when we come to our section on stock market investing. Our point today is that most of what you are likely to get from your investments is beta — or market returns.
‘Micro’ analysis (studying things in small detail) helps you pick the right stocks. But if you’re going to find the right market, you need to pay attention to macro analysis.
Should you be in stocks or bonds? US stocks or Russian stocks? Real estate or cash? These are macro questions. Also known as ‘asset allocation’ questions.
Your answers will largely determine how well your investments do.
Writes Bonner & Partners editor-in-chief Chris Hunter (a big believer in beta over alpha):
‘In 2000, Yale professor Roger Ibbotson and Morningstar’s Paul Kaplan studied 10 years of monthly returns of 94 US balanced mutual funds and five years of quarterly returns of 58 pension funds.
‘Their conclusion: About 90% of the "variability" in returns of a typical fund (its ups and downs) across time was explained by beta, not alpha.
‘And a more recent study by François Trahan and Katherine Krantz showed that 71% of the movements in financial markets are the result of macroeconomic trends, yet 69% of all investors are focused on micro, or company-specific, analysis.’
Right place, right time
Being in the right place at the right time is far more important than trying to pick individual stocks.
But how do you know which is the right market? Which market will give you positive beta?
There are plenty of researchers — mostly academics — who claim to have proved you can’t consistently time the markets. You just have to take what the markets give you. Anything better is just luck.
There is also plenty of research claiming you can’t hope to consistently pick stocks that ‘beat the market’. They think positive alpha is luck, too.
In our opinion, based on three decades of observation and study, they are wrong…for reasons we’ll outline in another instalment in this series.
But let’s not get distracted. We’re after positive beta. And the way to get it is to see as clearly as possible what is going on in the big wide world of finance so we can put our money in the market that is most likely to go up.
When you are analysing a company, you pay attention to details — products, profit margins, technologies, competition, management and so forth.
When you analyse markets you need to look at other things. Some companies will innovate successfully. Others won’t. Some will capture more market share. Others will lose market share. Some will invest their money wisely. Others will squander it on buybacks and LBOs.
But looking at markets as a whole, you need to look at the larger context. You need to understand, for example, that markets are cyclical. They go up. And then they go down.
Everything Is cyclical
Imagine two different stock markets, side by side. One has been going up for the last 10 years. The other has been going down for the last 10 years. Which one is likely to be the best beta choice?
The recent winner or the recent loser?
The answer is it depends. But when a market has been going in one direction for a long time, the odds increase that it will change course.
‘Trees do not grow to the sky’ is the old expression on Wall Street.
Another way to look at it is as ‘reversion to the mean.’
Whenever there is a mixture of skill and luck involved in a series of outcomes — say, corporate profits or stock prices over time — outliers tend to move back toward the long-term average. That’s mean reversion.
A company may innovate and grow for many decades. But markets tend to move in cyclical patterns: up, then down, then up again.
Some markets are more cyclical than others. Take the ‘hog cycle’. When the price of pork rises, farmers increase their production. When it falls, they cut back.
Because the gestation period for swine is 114 days, there is a regular and predictable lag. Prices go up. Farmers raise more pigs. Increased supply causes prices to fall. Farmers raise fewer pigs and then prices rise again.
Almost everything in nature is cyclical: You are born. You mature. You grow old. You die.
We wish it didn’t have to be that way…especially the later stages. But that’s the way it works: The day dawns. The day ends. Winter gives way to spring. On and on forever.
But markets also have an aggregated ‘brain’ and strong collective emotions. Investors look ahead. They try to anticipate the cyclical changes. And so doing they imprint their own thoughts on market prices.
If they anticipate more price increases, they buy. This moves the ultimate market crest forward.
As prices rise further, it acts like the pull of the moon on tides. Investors see their friends making money. They are galled and envious. Soon they are buying too. And prices go higher.
Finally, so many people have bought in that there is little money left to bid prices up further. This is the ‘top’ — when people are confident that things can’t get any better.
That is when investors are most likely to lose their sober perspectives. Yes, markets are treacherous. They appear most benign when they are most dangerous.
The first secret to getting positive beta is to learn to make this psychological dimension of markets work for you, not on you.
You’ll find out next week. You’ll also learn about another treacherous adversary in your quest for ‘positive beta’.
And we’ll tell you where we think you’re most likely to make the highest beta returns in the years ahead.
for Markets and Money