Lessons Learned Amid Cognitive Bias For Investors

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Includes: EEM, FXI
by: Robert Duval

Summary

Cognitive Bias greatly influences how we see the world and resulting investment decisions.

Investing scars in a post-crisis world can last much longer than the actual crisis period.

Confidence can be slow to return, even at the executive level, slowing the economic recovery.

Emerging markets may be the next overlooked opportunity.

It's been a challenging few weeks for me as an investment professional.

As the WSJ has publicized, active managers are having one of their toughest years ever, as the halting, slow economic recovery has been a source of uncertainty for so many. I am no exception.

I have been looking for an intermediate top for some time, as I felt the combination of what has appeared at times to be an anemic recovery, weakness in Europe, fully valued US equities, very bullish sentiment, and a reduction in FED accommodation, was an unsustainable mix for the most highly valued areas of US equity markets.

I have tried shorting certain indexes and high valuation stocks on several occasions in the last few months -- with negative results, overall. This has degraded what was an excellent investment year, now is only middling.

I've changed my view, and focus somewhat, while still advocating caution on US small caps and other expensive areas of the market, like social media and "momentum stocks."

First I will lay out where I think my assumptions may have been wrong, and then look at the remainder of the year ahead and where opportunities may be presenting themselves. In this exercise, I hope you can identify with my "bias" that has limited my results, and perhaps identify your own.

I have assumed -- that the extremely slow recovery in the US, has meant a heightened risk of a failed recovery -- and a return to US recession down the road -- due to the apparent weak recovery in US housing, retail and by association, the consumer.

I am shifting my viewpoint somewhat to a more constructive view, that the recovery is proceeding, just very slowly. I believe I have greatly underestimated the "shock value" of the events of 2008, following the bear market of 2000, and its effects on long-term investor and consumer confidence -- and that of corporations to engage in expansion, hiring and Capex spending.

I also have to deal with my own bias, and this is the main point of this article. I began trading in 1998, just in time for the Asian Financial crisis. Myself, and my peers at the time on the stock index trading floor, always favored a fast bear cycle, profiting from the increased volatility and emotion. This, became "normal."

I very successfully traded the 1998 crisis, and made my initial career on the 2000 bear market, shorting aggressively as the tech sector unwound its overvaluation. I also traded 2007 / 2008 fairly well, as the volatility created many opportunities in both directions for the short-term trader. Volatility, became something not to be feared, but embraced.

After 2008, as I began more and more to focus on individual US stocks and less on indexes, and lengthen my holding periods, I successfully placed a number of "long side" trades, especially during periods of high anxiety where a clear setup existed -- but I always had a slight leaning to the "bear" side -- as that is the type of market I began in.

I have never been exposed, to a secular bull market, and I began to underperform in the slower, grinding bull that has existed, through much of 2010, parts of 2011 and 2012, as I would exit long side trades prematurely, and switch to "short side trades" -- with very mixed results, at best!

The path from a high volatility trader, to an intermediate-term investor (let alone long term) has been as slow and torturous as this economic recovery, and I still have a long way to travel. As far as I know, I am the only one of my former floor trader peers to even attempt this transition. Most, as of today are completely out of the trading business -- and they are some very smart individuals that simply could not make the transition.

Today I believe, simply, the central banks remain in place, to ensure confidence in the financial systems in the US, Europe and Asia, until such time, as economic participants are ready to take the "handoff" -- and have the confidence to engage in economic expansion.

That handoff may be gradually occurring in the US, where Europe is a few years behind -- but the ECB is there. Therefore, in such an environment, taking any kind of significant short position is both risky and illogical. Sentiment and valuations are elevated, but not remotely at 2000 levels, while interest rates are far lower.

That kind of risk scenario, (2000 euphoria and valuations) may likely return, but is not in place today -- and in any event, would likely be preceded by elevated inflation readings and associated higher short term interest rates -- those would be signs to watch. The reason true euphoria is so slow to develop, is lingering "scars" from the 2008 crisis in the minds of many investors. This may be why; we do get elevated sentiment readings, that never seem to be "sticky" -- folks become fearful and bearish, very quickly.

I do continue to be cautious on US small caps -- they look tired -- however other opportunities are opening up, partly perhaps due to rotation, and partly -- possibly -- as a result of ECB accommodation -- and that is the pending breakout in (NYSEARCA:FXI) and (NYSEARCA:EEM) markets.

EEM Chart

EEM data by YCharts

FXI Chart

FXI data by YCharts

I am growing very bullish on these areas, and have been for some time, as they have done nothing in several years as the SPX has gone straight up -- valuations are attractive and sentiment muted. There again, investors need to face their "bias" that the US is the only "safe" market to invest.

Best wishes to all investors!

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.