The Costly Craving For Explanation

|
Includes: DIA, IWM, OIL, QQQ, SPY, USO
by: Jeff Miller

Summary

There is a strong correlation between oil prices and stocks.

Many of the stocks should not really reflect oil prices.

The quest for explanations has led many to reach.

Be suspicious of post hoc theories!

Opportunities abound for those skeptical of the facile pundit analysis.

Everyone following markets wants to see order, even if the data present only chaos. Humans reject random data, imposing explanations instead. They see patterns that reflect normal probabilities. They look at zillions of cases and celebrate a single instance that confirms a preconception.

Because behavioral economics has been so widely celebrated, Nobel Prizes awarded, and proponents publicized, it seems like we should have learned something.

Not so!

People are schooled to buy when others are fearful, but it is easier said than done. Similarly, and despite the warnings, it is easy to fall into the trap of imposing order on chaos. Larry Sessions has great examples from nature.

This imposition of patterns on chaotic data is correlated with intelligence. One of my early classes in methods (one that seems to have been omitted by many current Wall Street experts) emphasized the need to start with a hypothesis. I wrote the story almost ten years ago. I encourage you to laugh and me and my classmates by reading the original (not very long), before the spoiler below.

If you read the link, you are laughing. If you did not here is the key point. The professor started with conclusions and then asked for explanations. He got some persuasive ideas. Then he surprised the class by revealing that the relationships were all the opposite of what he had originally told them!

This is an extremely important lesson. Analyzing lots of data, with hundreds of possible relationships, will always yield some findings - statistically significant! Fertile minds can figure out some logic to explain these findings.

That approach is backwards. Good research begins with theory and hypotheses and then moves to testing.

In one sense it is a shame that Wall Street researchers did not get this kind of training. If one looks carefully at their reports, it is pretty obvious when a researcher is "data mining" and when there is some theory behind the work. A key question is: Which came first?

The Current Relevance

For many months, stocks have traded in line with oil prices. These prices are seen by some as an important economic indicator - better than the various official data sources.

Forget that (the occasional) successful past examples of commodity indicators occurred when supply was stable. Demand was driving prices, which is certainly not the case now.

Forget that demand for oil has increased at a growing pace.

There is an obvious trading pattern. It is the mission of the media to make sense of this. It is so oft-repeated that many have joined the regular pundits, providing imaginative explanations. This group now includes some top economic journalists and economists.

The conclusion, in various forms, is that declining oil prices provide a signal for a U.S. recession and the need to sell stocks in all sectors. It is important for investors to evaluate each idea that might affect the economy and the value of their stocks.

The data show the following:

  • Commodities have frequently provided false recession signals, most recently in 2011;
  • Stocks also famously provide bogus recession signals;
  • Recessions rarely come from a "stall" but actually from a cycle peak.
  • Most important economic indicators are still growing at a sluggish but solid pace.

Why the Skepticism?

Markets have increased in volatility, moving from a little below the long-term average to a bit above it. There is an obvious daily correlation with oil prices. To the media and to pundits, this demands an explanation. Here are the candidates. I am open to any idea, mostly because I want to be on the right side of major trends. None of these make any sense. In each case, I will list a popular allegation, followed by the result of my own checking. Each topic probably deserves a separate article, but few seem to be studying the actual data.

  • Sovereign wealth funds are bailing out of the stocks, selling whatever they can. The amounts of stock holdings in these funds does not correspond to the amount of selling.
  • Capital spending is declining from less U.S. oil development. Once again, the numbers do not come close to explaining the stock declines. There is also no understanding that capital looks for the "next best" opportunity.
  • Employment is declining in some areas. Job losses from the oil sector are easy to see. Job gains from the benefits of low oil prices are tougher to spot.
  • Banks are exposed to oil loans. This is another statement that is true, but not important in quantification. Bank reserves for these loans seem fine. Everyone is eager to be the first to predict the next 2008, so that is the story.

Conclusion

There is a very simple explanation for the oil/stock trade: It has been working. Traders do not care about the reasons behind a correlation. I have reported (but no one seems to have noticed) that stock traders are following oil and oil traders are following stocks!

At some point, the economic reality will become clear and trading will focus on the next "new" relationship.

If you are a trader, you must recognize what is driving the market - either outguessing the others and/or cutting back size.

Investors should not be bamboozled by poor explanations. If you have a real sense of value for your holdings and your shopping list, you are getting an opportunity to act. I particularly like technology (including AAPL), regional banks, auto companies, biotech, and some airlines.

The Final Test

Let us go back to when oil prices started to decline. Was anyone suggesting that this was bad news for the sectors listed above? Or for companies that consumed fuel?

The explanations came after the fact - the best indication of bad methodology.

The craving for explanation is a normal human desire - but often a costly one.

Disclosure: I am/we are long F, AAPL.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Long regional banks