Just before Christmas we sent out a brief email to some contacts asking for their thoughts on 2009.
The response was woeful. The only comment we got back was from Rob Mulcahy, senior foreign exchange dealer at CMC Markets in Sydney.
Well, based on today’s Australian Financial Review and articles from The Australian over the past week, we are obviously mixing with the wrong crowd. There are predictions left, right and centre.
Is there anything to be learned from these predictions? Will they make us any money? Or should we just take the advice of our old pal Chris Tate who thinks predictions are about as useful as “picking Tattslotto numbers.”
According to The Australian newspaper, its best stock picker for 2008 was Geoff Wilson from Wilson Asset Management. He returned a stunning 42% drop in the value of his recommendations for 2008! Oops!! Of course, we are sure Wilson will claim that portfolios and asset allocation was amended throughout the year.
Over at the AFR, eight of their expert economists are bullish on the market for this year. That makes us worried. To be fair, we have also gone on the record to say that we wouldn’t be surprised to see the S&P/ASX200 back up around the 5000 point level by the end of this year. But we wouldn’t bet our house on it.
But let’s be honest. Predictions aside, in the world of blue-chip investing, there really isn’t any excuse to return a 42% drop in client funds – regardless of market conditions. An actively managed portfolio should have been drawing client funds out of the share market from at least late 2007.
Naturally, fund managers will claim that it is ‘time in the market’ not ‘timing the market.’ Tell that to investors who have lost half of their wealth in the last twelve months.
But the one thing we notice in today’s AFR is the absence of one section of the market.
There is not a single mention of the small cap sector – not that we’ve noticed anyway. This is amazing. Considering that since the market bottomed out on the 20th November, our small cap portfolio in the Australian Small Cap Investigator has brought in a healthy 20.88% return.
Of the 18 stocks in the portfolio, over half of them have outperformed the broader blue-chip index.
The S&P/ASX200 by comparison has only returned 10.76% since the November low. Will this out-performance continue into 2009? We think so. Here’s why…
The smart money in the market will be doing two things. It will be looking for value and income. “Doesn’t it do that all the time?” you may ask. It tries to. Remember, investors were trying to do that throughout 2008.
The only problem with that is the market kept going down.
So, the smart money will look at the blue chips and say, “well, I know you’ve taken a beating, but even if you do cut your dividend I’m happy to buy because the Australian economy is likely to recover in 2009/2010.”
As for value, well, you can bundle that up with growth at the moment. And the best place to look is the small cap sector. That’s why we are seeing such a strong bounceback in our portfolio. Let’s put it this way, assuming I have picked my income generating shares for my portfolio, I now want to balance that with some growth potential.
But only for a small part of my portfolio. So how do I do that? Well, it’s been a dirty word for the last twelve months, but the word is ‘leverage.’ But let me clarify that. I’m not talking about margin lending or securities lending or options, futures or CFD trading – although if that’s your bag, go for it. What I’m talking about is ‘synthetic leverage.’
By that I mean taking positions in the market that will give you a magnified return. Yet unlike some other forms of leverage, using this strategy, your downside is known. The most you can lose is the amount invested if the share price goes to zero.
The best place to get this ‘synthetic leverage’ is in the small cap market. It isn’t for everyone, and it certainly isn’t a sector that you would tie up a majority of your portfolio. But that’s the beauty of small cap investing, you don’t need to bet your house on it. You can get away with just putting in 5% or 10% of your portfolio and potentially see that grow by 50%, 100% or 200%.
We’ve shown that’s possible with a 20% return in two months! And if things don’t work out? Then the downside is only the amount you’ve invested.
If you do that, and actively manage your blue chip investments, chances are you’ll pull off a better return than the fund managers staring into their cracked crystal balls in today’s AFR.
Cheers.
Kris.
The Folly of Predictions
By Chris Tate
As the traditional festive season activities of inappropriate gifts and drunken relatives who overstay their welcome begin to wind down, the financial community begin their own odd round of end of year activities.
Each year at this time financial commentators and analysts begin to give us their predictions for the coming year. As you can tell by the title of this article I believe that this sort of activity has about as much basis in fact as picking Tattslotto numbers based upon the number of circuits your labrador does before plonking its backside in the corner.
My reason for such cynicism is simple – predicting the future is impossible. The reasons for this impossibility range from the philosophical to the quantum but I only want to concentrate on two that are very pertinent to investors.
Consider the two charts below – these are my predictions the XJO index for the next three years.
Both of these charts look like plausible outcomes for the index. In fact I could make a case that they are the result of some extremely complex modelling involving a series of fractal based equations. Unfortunately they are not.
These charts were generated by a simple random number generator and they are in all aspects identical, except one. A price shock of 3% was introduced into one of the charts at a random interval. This minor change completely altered the trajectory of price over the life of the charts.
This leads me to my first reason as to why markets cannot be predicted. Small perturbations in the initial seed conditions can and will create dramatic alterations in outcomes. This is one of the cornerstones of chaos theory – it is also impossible to account for all these tiny changes and to be aware of the magnitude of their impacts.
Financial systems are enormously complex entities where small changes that we may be completely unaware of can have dramatic consequences in the future. For a financial analyst or commentator to be able to predict the direction of a stock, index or currency overtime they would have to be aware of every single economic, social, geo-political and psychological input into the market over the coming twelve months.
Clearly such an endeavour is impossible and to believe that it is borders on being delusional.
To begin my look at the second reason as to why predicting the future of markets is impossible I need to take a look at the actual models economists and forecasters use.
Milton Friedman and Eugene Fama put the standard model of economics as a financial tool for markets forward in the 1950s.
The central tenet of such an idea is that prices will over time move towards their true and proper value. This concept is founded on two ideas. Firstly, people have strong motivation to work out what something is worth. The motivation for doing so is to avoid the potential for loss. People would not pay too much for an instrument. For example, let’s assume you wander down to the local Milk Bar and discover that a litre of milk was $19. As a rational individual you would quickly form a view as to the value of a litre of milk and conclude that based upon your experience $19 per litre was too high.
The second point relates to point one. The markets act as collective information gatherers where all available information is pooled and then acted upon. In essence the market is a giant version of Google. Everything that can be known, is known, and is available to be known. Thus, any aberration in pricing is quickly extinguished by the markets collective knowledge of what something is worth. This ensures that there are no sudden swings or shocks to the market, or so the theory goes.
Unfortunately for modern economics, aka the dismal science, shocks have been hitting the market about once every decade. The problem is economists don’t seem to have noticed these shocks much less been able to predict them. As such, any contribution they might make to the subject is somewhat meaningless.
Traditional economics is based on the concept of equilibrium within financial systems. This equilibrium is maintained by the clean flow of information and rational responses by investors. This leads to post hoc rationalisations about why the market behaves in a given way. For example, you will often hear the expression “the market went down on profit taking”.
Unfortunately such explanations are generally wrong. Fortunately researchers with backgrounds outside of economics and traditional finance have taken up the challenge of finding out what is actually happening in markets. As a result the evidence against the equilibrium view of economics is piling up.
In their recent paper titled Stock price jumps: news and volume play a minor role, physicists Armand Joulin, Augustin Lefevre, Daniel Grunberg and Jean-Philippe Bouchaud found no correlation between news items and the responses of stocks. They analysed the news feeds from both Dow Jones and Reuters (the major sources of information for financial analysts and journalists) and examined the correlation between hundreds of instruments and some 90,000 news items over a two-year period.
Their conclusion was there was no link between jumps in instrument pricing and news items. Most changes were not directly attributable to any news item at all and the majority of news items caused no change in instrument pricing at all.
This means that if the models that economists and analysts use to explain market behaviour are incorrect then any prediction based upon these models must by definition also be incorrect.
I understand the desire for prediction. Markets appear to be disorderly places and we place our trust in experts to guide us through the fog of investing. Unfortunately this faith is misplaced, experts do little more than guess and anyone can guess. The question therefore is where does this leave the average investor?
My feeling is that the answer to this is quite simple. Investing or trading is a reactive endeavour – your react to changes in price you do not predict them. This means you surrender your illusion of control but in doing so you free yourself to make decisions based upon what is happening with price. Not what you think is happening.
Chris Tate – www.artoftrading.com.au
for Money Morning Australia.
Editor’s Note: Chris Tate is a trading veteran of 30 years and one of the first people to ever release a sharetrading book in Australia. Best selling author of ‘The Art of Trading’ and ‘The Art of Options Trading in Australia’, his brutally honest approach and meticulous pursuit of excellence qualifies him as Australia’s foremost derivatives trading expert. To find out more about Chris Tate visit www.artoftrading.com.au
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