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Debunking Two Fallacies Of Apple Short

|Includes: Apple Inc. (AAPL)

(I wrote this few weeks ago. This was meant to be an article but I just got too busy to copy-edit it. If you happen to see this post, enjoy!)

I always appreciate SA editorship. Rigorous reviews make great writings. Believe me, publishing the first article is SA is tough, the editorial standard is very high. So you can rest assure that what are you are reading quality material.

The philosophy of SA editorship seems to allow both bulls and bears to express their opinions. As an Apple long, I appreciate articles that were written by authors such as Rocco Pendola who understands what Apple truly operates. You can see that from his articles such as "Why Apple Should Not Pay A Dividend (Or Do Anything Else Incredibly Stupid)" and "MBAs, Gimmicks and Apple's Culture" which I found highly reasonable and entertaining.

On the other side of the coin, I also love to read the counter arguments of why Apple (NASDAQ:AAPL) is a bad investment. I have no emotional attachment with Apple. In fact, I bought my first few stocks of Apple before I bought an IPod in 2005 at around $80, dumped it at around $160 because the sub-primed mortgage problem started to heat up. I loaded some at $230 again and have been increasing my position ever since.

I own some Apple products as they are more fashionable than its competitors'. In my mind though, I buy Apple stocks because they make profits for me. No more than that. If I see something bad about Apple, they will be gone from my portfolio few clicks later.

That brings us to why I wrote this piece. Recently, John Tobey wrote a great article "Apple's Shareholders Expect Too Much" and is the type of the articles I truly want to read. In the article, Mr. Tobey laid out well-found arguments on why Apple shareholder shouldn't have wishful thinking on the stocks. I have read it in detail and learned a lot from the piece.
Yet, I did find Mr. Tobey made a mistake. In his article, he quoted the "Law of Large Number" from a New York Times piece. Though I found his other arguments are sound, both his and NYT's use of "Law of Large Number" is not entirely convincing. I commented on his post and here is the excerpt,

"Statistical law such as "law of large number" or "regression to the mean" are meaningful when you talking about certain random processes. So when you use this kind of statement, it's better to state clearly "law of large number of X".

In the NYT article (and yours), it is unclear what we are talking about.

Is it the law of large number of capital? or earnings? or growth? If these are the 3 things, short term signals show that they are growing strong in Apple. Yes, it is possible that later these 3 quantities will go down. What we really concern then is when. As you are not working with timing, it makes the argument a little bit meaningless.

Then you can say it is law of large number of "innovation" (whatever it really means). Again, I found it quite vague and not really explain the process."

Mr. Tobey's answer in verbatim:

"You and an earlier commenter correctly point out that the "law of large numbers" is a statistical concept dealing with sampling. However, another use of the phrase is perhaps better put as "nothing grows to the moon" or some such truism. My point is trying to remind investors that per share numbers and percentage growth rates can hide the challenging reality of big, bigger, biggest. Similar to the 64-square checkerboard 100% growth rate from square to square - where 1 penny ends up as $184 quintillion. Doubling $92 quintillion is certainly a different challenge than doubling a penny.

And your timing is perfect, with AP's just-released article, "Apple's market clout likely to draw more scrutiny" ( I had actually deleted a section from my article discussing the regulatory/legal problems large companies run into because I thought it would simply inflame emotions and take away from the real message. "

I later commented that I understood sayings such as "nothing grows to the moon" and "no free lunch" are words of wisdom. I also felt that interpreting "the law of large number" and "regression to the mean" make investors to act more conservatively and often more wisely.

Nevertheless, I was more reserved if I should accept these sayings fully. "Nothing grows to the moon" is a great idiom. But if you think about this human had achieved many things that we thought was impossible. Two thousand years ago, the ancients would say "Nothing human-made can go to the moon". Of course, we knew it is wrong.

Conventional thinking can teach us a lot. Yet it doesn't always apply to every situation.

I don't blame Mr. Tobey. He is a very experienced guy so I felt only grateful he is willing to share his view. His other points are very reasonable. Some attacks the unrealistic targets made by Apple long and pundits alike. I recommend all of you to read his piece.

What bugs me more is the decision process of many investors (or even SAers) on why they decided to short Apple. Misusing "law of large numbers" and "regression to the mean" are classics. Those laws, when you look at it closely, works well on simple situations such as coin flips or processes such as coin flips. That's why mathematicians love to talk about them because they have nice properties. There are some situations where these theorems are perfect. For example, in many cases, the probability you can extract a card from a deck can be thought as a biased coin. That's why professional poker player love to use these mathematical tool as well.

Mathematically, you can extend the "laws of large numbers" with other processes, or more geeky speaking, probability distributions. But when you apply these laws, you still need to be very circumspect.

Stock price is one of the examples. We need to remember the stock price of a company is way more complicated than just coin flips. News and strategies of big players seem to affect a company's price more.

My sophisticated readers would say quantitative finance suggest that stock price can be modeled as normal distribution (or the Bell curve) and they priced options based on those assumptions. You need to beware though those assumptions may or may not work well in specific situations. That explains why some quants are earning huge bucks, some are struggling.

Moreover, can you really use a Bell curve to model Apple so far? If you couldn't, how come it follows these "sacred" statistical properties all the sudden? In fact, a line which point north seems to describe Apple's stock price much better than 100 other distributions.

Another one of my favorite misuse of "law of large number" is the "law of large number of innovation". What is supposed to mean is that a company's innovation (whatever it means) will regress to normal as its size (no matter how it is measured) increased.

If you just use a bit of common sense and think about the statement, you will realize that it doesn't make sense at all. First to realize: human is not a coin nor it can be modeled easily. Say Jonathan Ive, the chief designer of Apple, and we all know he is an innovative guy. Has he become less innovative as the company goes bigger? Unless some things tragic suddenly happen to him, like his head was hit by a brick, how come he would become not so innovative all the sudden?

Wait a minute! I know what you are thinking, you will say "No!. Apple is a big tech company, without a strong and dictator-like leader such as Steve Jobs, then a designer such as Ive would be hampered and not being able to do as much. " Now, that's a reason. We know it is true that Jobs was a cult-like leader in Apple, he flipped the usual political positions of engineering and design for a tech company. That was why a designer like Ive can prevail in a product discussion. In my opinion, it is indeed a question when Jobs had gone, how long Apple's innovative traditions can last.

But you may also notice that "Steve Jobs is the cult-leader" argument has nothing to do with the "law of large number" or "regression to the mean". In fact, I think this "Steve Jobs is the cult-leader" argument is quite insightful and it may really explain the downfall of Apple. If you read the very interesting book "Inside Apple" by Adam Labrinsky, you will learn more about this argument.

You may also notice that though "Steve Jobs is the cult-leader" argument is sound, it doesn't give you an immediate reason to sell today. It implies that you want to do a "hold and sell when you see correction".
Enough for the misuse of statistical sayings, I said in the title that there are two fallacies. Statistical laws are the first one, so what's the second?
It comes as the following form,

"Recently, Apple is plagued by issue X such as the instance ________. In future, it is more likely to be plagued by issue X as well." Here issue X can be legal issue, labor issue, environment issue or whatever issues you like to fill in.

The problem of this kind of arguments is that it doesn't account for the fact that these issues were known by Apple investors for a long time.
Want another one? Let's say this one is bonus material.

"The Market is unpredictable and we never know what the right timing is to buy or sell Apple."

True. The Market is unpredictable. Also true, it's tough to find the right timing to buy/sell Apple. But when the Market is unpredictable, doesn't that mean all the stocks are sensitive as well? How come Apple is singled out? Why bad luck just falls for Apple and only Apple?

If I read it right, this type of statement simply reflects a negative sentiment of the speaker. It is likely to be spoken by people who went through the tech bubble 10 years ago. 10 years ago, S&P was overvalued. More importantly, the tech world has much wishful thinking and non-consequential ideas floating around. We also just started to understand how technology such as internet can change business models.
Applying the thinking 10 years ago to now is unwarranted and irrational.

Being conservative is a good thing, but unfound fear will confuse your decision. If you want to palate market risk better, you can use tools such as diversification and dollar cost averaging to palliate the risk. Again though, "Market being unpredictable" is not a reason to suddenly dump your Apple out.

As an investor, you got to remember rationality is always your friend. Only with superior reasoning you can win in trading. Wishful thinking and logical fallacies can occasionally bring you profit. But in a long run, wins from "good luck" and losses from "bad luck" really cancel out each other. I hope this article can help you to understand some common and false arguments against Apple. Not using them may be the true beginning of your profitability.

BTW, I am still searching for the true reason why I should sell my Apple. If you believe you have something interesting. Feel free to comment. I'll love to hear what you think.


Disclosure: I am long AAPL.