John Burbank of Passport Capital gave a presentation at the Haas School of Business at UC Berkeley earlier this year that has been making its way around the internet. If you have a spare 60 minutes, I’d highly recommend giving it a watch.
In watching the lecture, there was a point John made that highly resonated with the investment philosophy we have here at Newfound.
First, let me rewind a bit.
A few weeks ago, I had the pleasure of participating in a dinner with a group of high net worth clients of an advisor group we work with. The focus of the dinner was to provide a forum for these clients to learn about Newfound and ask any questions they might have about our philosophy or process.
In describing our momentum-based process, one guest asked me (and I paraphrase), “if you only use price, does that mean you think that price incorporates all information? Doesn’t that make markets efficient?”
Frankly, I bumbled my answer. What I was trying to say was price incorporates all the information we need to make our decision because price represents the equilibrium between supply and demand in the market. That does not mean, however, that markets are efficient.
This same guest then asked me about why the market fell after the Fed decision to keep rates lower for longer on September 17th.
I explained my view that most day-to-day market fluctuations are noise. In fact, immediately after the announcement the market actually rallied fairly significantly before crumbling into the close.
I’ll note that the very same market that crashed after lower for longer just rallied on lower for longer. Go figure.
The reality of day-to-day markets, I said, is that there are plenty of people buying and selling for no economic or fundamental reason at all. Consider these examples:
- A hedge fund has a very large position in a low volume stock they want to liquidate. They cannot sell all at once, so to try to lock in their gains they short a basket of stocks in the same industry group, or even a highly correlated ETF. They now have a hedged position that they can unwind over time to minimize market impact. The short-sales on the stocks or ETF have nothing to do with a negative view on the industry – yet should negatively impact the prices.
- A large endowment has a significant liability it must meet. Therefore, it liquidates assets. This liquidation has nothing to do with economic forecasts or fundamental views – it is entirely based on personal economics. Yet it will have a negative impact on the market.
- A market making firm might make a large purchase of call options and then sell stock to hedge out their exposure. This may put downward pressure on the stock but has nothing to do with their view on the fundamentals of the company.
All of these reasons could move markets. Yet our day-to-day narrative requires a better story.
Josh Brown, over at The Reformed Broker, posted a tongue-in-cheek list of explanations for “why the stock market sold off” a few years ago based on the different reporting news sources. Fox Business was “Obamacare.” CNBC was “It didn’t sell off at all, it was actually a reverse rally.” History Channel blamed it on “Ancient Aliens.” You can read the full list here.
Humans love a good narrative. The reality is, while a boring explanation is more likely to be right, an interesting explanation is more likely to be believed.
The boring explanation is that price represents nothing more than the equilibrium pressure between buyers and sellers. People buy and sell for all sorts of reasons.
Fortunately, John Burbank has now turned this boring explanation into an interesting narrative: “Price is a liar.”
John acknowledged that as humans, we love unifying theories. The idea that price contains, and reflects, all relevant information (which comes from the efficient market hypothesis) is a nice, neat, and clean unifying theory.
In reality, it just isn’t true. Just like any other economic market, price simply reflects the equilibrium of supply and demand at a given moment.
When something new happens, it takes a very long time for all the world’s liquidity to appropriately price in the information. It takes a very long time for everyone to agree on the main thesis.
With true secular changes, there is nothing in our historical data or collective experience to provide insight into what is happening. These changes often have a non-linear impact on our world. Humans are very bad at extrapolating non-linear relationships.
So markets are actually quite bad at discounting true, secular change because these changes diverge very meaningfully from our expectations.
Despite people talking about a housing bubble and credit derivatives back in 2006 and 2007, the S&P 500 took nearly 18 months to make its peak-to-trough move.
Consider the dot-com boom and bust. Everyone agreed that the internet was a revolutionary tool, but did the market appropriately discount the change? In 2000, it put absurd prices on internet hardware companies (e.g. CSCO). But in 2015, it is thesoftware companies that now demand the multiples.
Nobody in 1999 appropriately discounted for a cell phone in every person’s hand, the impact of open source software, or the rise of demand in cloud computing. Nobody appropriately discounted for software eating the world.
The beauty of a trend following methodology is that it does not require us to try to appropriately discount these global secular changes.
We’re not trying to predict the non-linear impacts. Instead, we simply recognize that price changes are just the market working out these impacts over time. As markets digest the information and change their fundamental or macro-economic view, so will supply and demand. By using a trend following technique, we can adapt with the market’s changing expectations.
So don’t bother trying to work out the day-to-day narrative of the market. Ignore CNBC. The market moved because there were either more buyers than sellers or sellers than buyers. And in the day-to-day, it’s often meaningless. What we should care about are the long-term trends that this buying and selling pressure creates.
Those trends are the market slowly building a consensus that we shouldn’t ignore.
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