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Can we hear the shape of the market?

June 8, 2012

Why would anyone think that the market can be described by the “market line” – technically, a hyperplane in a 10s-, 100s- or even 1,000s-dimensional space of stock price returns – and a handful or even hundreds of “alphas” and “betas” that are churned out by the Capital Assets Pricing Model (CAPM) and Modern Portfolio Theory (MPT)?

To visualize that in a simpler space, say for two stocks, throw a handful of salt on a sheet of paper and draw the best fitting line through it. The axes can be drawn as an afterthought and placed anywhere and we’ll still have the same result.

Would that not be the same as describing Beethoven’s Fifth Symphony as a regression line (C minor) and a handful of artful allegros? Indeed, and should we then expect anything other than blah blah, blah blah, from such a description of our music or the market?

Our aural pain does not end there because we pay a generation of portfolio managers, the “musicians” so to speak, to “play” but not to “perform”. But how can they perform if they can’t read the score and all they have is “overweight” or “underweight” using the same statistical model that re-wrote the music in the first place.

And why should they “perform” while harvesting 2% or more of our net worth every year by just showing up to play and looking good in the tuxedos that we bought for them? As a result, a generation of savers and investors can’t retire and are singing the Blues.

It’s time to smarten up. Instead of buying markets, balanced or “unbalanced” and glibly called global or emerging, we need to buy companies, individual “oscillators” so to speak, singing a tune that we might like.

We can understand companies and it is a fact that in any market – bull, bear, or indifferent – for any company “there is a least stock price at which the company is likeable” (Goetze 2009) and therefore “embraceable”.

One can then go on to show that the “price of likeability” is also a “risk adjusted price” that we usually call the “price of risk” (Goetze 2009).

The point is that if we know the price of risk, then stock prices above the price of risk are a “free good” in the economic sense of Say’s Law (1803 and subsequent) – they shouldn’t exist but they do because they represent an unanticipated relaxation of uncertainty among investors and defy the legion of “mean reversionists” and stentorian “fundamentalists” looking for “quality” goods at low prices.

What could be cheaper than “free” if all we really need to know is where and when to shop? Please see our Letter on The Dow Jones Industrials – (B)(N) There and Done That, June 2012, for an example.

CAPM is indifferent to economics (Stiglitz 2001 and many others) and investor preference for risk aversion and simply treats all the companies in the same way – as little oscillators fully specified by a mean and a table of covariance factors based on historical prices.

The weighting policies are intended to hopefully prevent “blah, blah” from showing up as “whump, whump” if the correlations are not as enduring as we hoped, and of course, “hope” is all we have when the much-touted “protective technologies” such as “Value at Risk” (VaR) and “Stress Testing” are used to guide management as to the size of the ear-muffs that we might require.

Disclaimer

Investing in the bond and stock markets has become a highly regulated and litigious industry but despite that, there remains only one effective rule and that is caveat emptor or “buyer beware”.

Nothing that we say should be construed by any person as advice or a recommendation to buy, sell, hold or avoid the common stock or bonds of any public company at any time for any purpose. That is the law and we fully support and respect that law and regulation in every jurisdiction without exception and without qualification to the best of our knowledge and ability.

We can only tell you what we do and why we do it or have done it and we know nothing at all about the future or the future of stock prices of any company nor why they are what they are, now.

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