Saturday, August 25, 2007

If A, then B, C, D. . ; therefore......

There were several good points made in the comments section. I'll address a couple. My coffee is not yet coursing through my veins, but I'll write anyway.

On Predictions and Time Frames:

I do believe that one can make predictions based on probabilities predicated on evidential matter. Business people HAVE to do it everyday. There has been discussion here that due to randomness and the like that outcomes cannot be predicted. To me the difference is between certitude and probability. And one hires a CEO and his/her team to accurately understand probabilities of success and ensure that they understand ACCURATELY the requirements for ensuring that success. But failures occur. An executive team's responsibility is to maximize outcomes even in the face of being wrong about an influencer of the desired outcome. You are the CEO of your portfolio. Accordingly, you and you alone have the final responsibility for making decisions about with whom and how your portfolio is invested.

Can one make a credible prediction about if/when there will be a recession? Yes--and the factors that throw one into a recession are many. Accordingly one needs a confluence of data supporting the argument for the probability of a recession, an if A, then B, C, D. . . . happens. I wrote an unusually excellent post (only because I quoted someone so much smarter than I!) on recessions. You can read the full text here: But since moving from post to post is disruptive, I'll copy from that post. These are the three elements needed for a recession according to Marty Zweig:
  • Extreme deflation characterized by a PPI index drop of 10% on a 6 month average of annualized m-t-m changes.Take current year m-t-m inc/dec and average it with the last 5 months (sum the mtm change each month for the last six months and divide by 6).If that 6 month average is at least –10% then you have cleared this test; (I've not calculated this. I don't think we are there. I think that with the ISM falling, we will BEGIN to see where that calculation becomes meaningful).
  • Ultra high price/earnings ratios.He labels 10-14 aS normal P/E range. Upper teens and twenties is what he calls high; and (we are in this level now).
  • Inverted yield curve.Zweig used the Moody’s Aaa Corporate Bonds yield as the long term rate and 6 month commercial paper rates as the short term rate. (I've not calculated this). Addendum 11.13.06--Of course we all know that we have an inverted yield curve, and SFO did a wonderful story on that which you can find here.
I'm also intrigued with the notion that upheaval in the financial markets can bring about a recession--they cause the recession rather than predict it. The linkage makes sense in a couple of ways. Way 1: The credit markets drive liquidity and when liquidity dries up (spontaneously combusts as it did last week) that reduces capital available. Way 2: Liquidity fuels asset prices, and when liquidity is removed to de-leveraging, asset prices fall and wealth is reduced. It's simplistic I know, but it's something that you must be aware of. At the very least, you use it as a backdrop to evaluate what you are hearing from experts.

You have to be careful in looking at this stuff. If A happens, then we have always had a recession. (that is what Arvedlund stated about housing downturns of the magnitude that we are witnessing.) V. all recessions are characterized by A (such as in inverted yield curve). Not all inverted yield curves lead to a recession, but all recessions were characterized by such. It's an important distinction. Re-read that line--and make sure that you understand that distinction. I listen to the experts, and I've heard them NOT make this distinction regarding the yield curve. You must develop your personal bullshit filter IF you plan to make decisions based on what you read and hear.

Can one really predict the time frame? That's the hardest thing of all. I would say that A 12 month -maybe 18 to stretch would be reasonable. Anything more is ludicrous and anything less means you are already in one. Let's remember, too, that recessions occur with fair regularity, as they are an important part of the natural business cycle that runs in 48-60 month spans. So one could make a relatively accurate prediction without having any data at all!

Now the tricky thing is predicting the magnitude of a recession. Trust me guys, no one can do this. No one.

Experts:

A reader leaves this comment: "I guess my real question here is, how long do you hang on to an expert's opinion before you realize that in doing so, you are making a mistake?" Forgive my long-winded answer to this very good question. Keep in mind this premise: You are the CEO of your portfolio and you and you alone are responsible for managing the outcome.

I believe that if you are going to use any expert's advice, you should put yourself in a position to evaluate it, so that you can make a rational decision based on objective assessment of data that you are bombarded with daily. There's a reason why my blog is called The Perplexed Investor. On any given day, you will have 1/2 dozen people who are very smart and very knowledgeable with an opinion different from yours as well as different from each others'. Rather than impugn the predictor, you have to take the weight of the evidence and judge it relative to YOUR risk tolerance and YOUR investment time frame.

Based on the weight of the evidence, then you are in a position to look at the "If A, then B, C, D...." after than come "therefore. . . I will do X". You make the decision and you accept the consequence--for good or naught. I write this blog as my public grappling with how I do the "If A, then". Personally, I think that the market has some deep, deep problems because of the credit markets. I've been expecting this stuff to happen for some time now. My lesson: One can see the cracks in the foundation--and people don't look at foundations, they look at walls--the market will not react until it sees cracks in the plaster. Actually, the market will probably ignore the cracks in the plaster and wait for chunks of it to start falling down!

Because of my deep distrust of this market, I'm mostly cash. I realize there is an opportunity cost, and I'm willing to accept that. I don't want to come in at the tail end of this bull market when I believe there will be a better buying opportunity. Yes, the trend is currently up--but it has been badly injured. I don't trust this market. Not a wit. I haven't trusted it since last year, so I've not built any long term positions. Oh, I lie--I was bearish, because I listened to experts and took some bearish stands that lost money. My current portfolio mantra is to make surgical strikes. I've had some reasonable success in stalking some prey to take advantage of market volatility. I took some short term positions which I believed had high probability odds of success. Having some intermittent success (and realizing there is as much an element of luck as skill) keeps my opportunity cost lower.

My not surprising conclusion is this: Do not use an expert as a hat rack. Use experts as tools. Have a bevy of experts, not just one. I read Bill, Gary K, Rev Shark, George Dagnino Tim Knight, among others. I listen to Jim Puplova's first hour show every Saturday, particularly the technical analysis. If every expert is seeing/saying something different, then those differences are telling you something.

Most importantly, you must understand (1) your own biases and (2) the biases of your chosen experts. I can tell you every week what J. Puplova is going to say about energy and gold. It is a broken record, so I don't consider it on a net, net basis either new or valuable information. Don't get me wrong. I'm not knocking J. Puplova--I listen to his show because he invites terrific guests whom he expertly interviews. Now if Gary K were to say, "Kiddo's get into gold and oil,"I would increase my exposure. Why? Because he's not a broken record. George Dagnino is not a broken record.

We want our gurus/experts to be someone we can unequivocally trust 100% of the time. We have to adjust our expectations to make them reasonable/rationale. To do that you must trust that your expert/guru will be wrong 40% -50% of the time and right 50-60% of the time. Let's revisit the premise--I know that I sound like a broken record, but it's a vital message. You serve as the CEO of your portfolio. And it is YOUR JOB to maximize outcomes with the information that you have available. You have to do the "If A, then B...., therefore, ........ And the "therefore" is your realm of accountability.

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