Housing Bubble Burst - Can You Catch It?

To be successful at investing, you have to constantly re-examine your assumptions. This is because you are constantly confronted with choices. Over time, you begin to realize that not all choices are of equal importance, and that for many important choices there is really no conclusive information to inform your decision. So you stay silent and watch.

You'll hear lots of back-chatter about short-term macroeconomic conditions and what implications they should have for your investments. People hate to be in an informational vacuum, so they listen to the noise in the circuit, even if it contains no meaningful or useful information. Much thought and agony goes into carefully positioning investment portfolios to capture macroeconomic trends. And thanks to ETFs, it is now easy to create focused portfolios and attempt to capture almost any investment theme.

Yet these concerns have almost no impact. They are only a distraction from the real challenge - finding cheap and safe investments.

In order to generate portfolio alpha from macroeconomic insights you have to satisfy three conditions:

1) Your conclusions have to be substantially different than market opinion.
2) You have to be right about your macro predictions.
3) Your insight has to be actionable.

The first condition is critical. If you read about it in Barron's, the New York Times, or the Wall Street Journal, it is too late. Everyone else knows about it too, and it has already been priced in. Because it is priced in, there is no excess risk-adjusted return; you are in accord with the consensus.

Let's take the nasty outlook for homebuilders (XHB) as an example. If you agree with the housing-bubble shopocalypse scenario it doesn't do you any good, because everyone else knows about it as well. Let's say you think that the housing collapse will be 3% worse than the market expects; it's still not enough to take actions that will generate excess returns above market noise. Given that the implied volatility of the S&P 500 [VIX] is currently about 12%, your predictions have to be at least that much different from the market consensus to have serious alpha impact. Therefore agreement with the crowd, or even agreeing with it more intensely, does not lead to excess returns. You have to be able to disagree, and greatly disagree, to earn a palpable difference.

Having correct macro insights is sort of obvious, except for the fact that for any given scenario you can get several interpretations, and usually the average of them is already priced in. In other words, most of the time everyone is partially right and partially wrong; it's a wash. The zone of indifference within 1 standard deviation [SD] of the mean estimate is quite large, and usually encompasses most opinions. Without pricing inefficiency, excess returns are impossible.

Finally your insights have to be actionable. For example, I think that there will be big impact from a tightening phase in the credit cycle. Sadly there isn't much I personally can do with this insight, since I don't have positions in high-yield bonds or leveraged equities.

Taking a prudent approach means you don’t have to worry about things that are unimportant to thoughtful investors. The long and short of it is: Keep your eye on that fat pitch, and do not get distracted by the cheering and booing of the fans.