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Is Profiting In The Stock Market Based On Illusions?

And 3 questions to ask to not be fooled

When I was a child, I was fascinated with magic and magicians. I read scores of books, learned loads of tricks, and put on magic shows (ten-cent admission) in our basement. My favorite part was the illusions (I once worked a part of a summer vacation mastering a very convincing floating wand).

Houdini was the mentor we had in those pre-David Copperfield days. He had walked through walls, escaped everything, performed death-defying stunts, and even made a live elephant disappear from a London stage!

This weekend I watched a fascinating bio-flick on the History Channel on Houdini's life, starring Adrien Brody. One of the best parts of the picture was Houdini's war on spiritualists.

In one dramatic scene, the magician is confronted by a spiritualist who accuses him of being as much a fake as the mediums that he sought to expose. His reply was that he had always said his tricks were just that and he was an entertainer, while the spiritualists made out that they were real and their customers often relied on their "information."

To learn more about the History Channel presentation or even watch it, go here.

As I consider the financial services industry, I wonder whether investors think of advisors as mediums rather than being masters of illusions. I sense that most think it is the former rather than the latter. How many times do you hear someone talking about an advisor as if he or she is infallible? Or listen to someone explaining a strategy or stock pick like it just can't lose? Isn't that the medium's game? The spirit world has to be right, doesn't it? Investors often want that certainty as well.

At the same time, investors don't want to believe their investments are built on illusions. There's a negative connotation to the word. As Houdini said, they are based on a "trick." You see one thing while something else is really happening. That doesn't inspire confidence, does it?

Yet on closer inquiry, both of these viewpoints are askew. While we look for the infallible expert and the perfect strategy, we know that such does not exist - at least in this world. And although illusions can be said to be based on "tricks," in reality they are based on a well thought out understanding of human behavior and the physics underlying the illusion's success.

A grand illusion (like making the elephant disappear or walking through walls) can take many years to develop. The illusion is based on the application of human ingenuity, not simple awe of an "expert's" opinion. And while most everyone who watches an illusion marvels in amazement, there are always those who can divorce themselves from the normal behavioral tendencies and focus on what is really happening - figuring out the methods. However, this failure to convince the minority does not negate the awe experienced by the majority.

Many times in this column I've pointed out the problems in relying on "expert" analysis. Study after study shows that experts are wrong more often than not when it comes to predicting future events. Yet we see these financial spiritualists performing their act daily on the various financial channels.

Meanwhile, I have been a proponent of quantitative-based strategies. These investment approaches are based not on opinion but rather years of study and solid mathematics. They are founded on statistical measures of human behavior. And while they are not always right, the research underlying them shows that they lead to success most of the time.
Financial "experts" seem to be closer to the mediums of old, while quantitative analysts follow methods similar to the creators of illusions. Realizing that they both can be wrong and that each has the potential to mislead, which approach seems best to you in managing your money?

If you choose the illusionist's methods, how do you know that the strategy results you are being shown are not "illusions"? Studies tell us that if one has to make predictions about the future, there are two things we can do to increase our chances that we are successful. According to Nobel Prize winner, Daniel Kahneman's, "Thinking Fast and Slow," this can be done by 1) following a rules-based approach and 2) looking to predict only a very short time into the future.

Of course, the first requirement is exactly what quantitative investing is all about. It tries to reduce investing to a set of rules that have proven successful in the past. Now, it is important to note here that by "successful" we don't mean every trade is a profitable one or even that every day, week, month, or quarter of trading is going to be profitable. It only means that past research demonstrates that applying the methodology through past market cycles consisting of both bull and bear markets has a better than 50% probability of yielding profits.

The second requirement makes sense too, doesn't it? We know that trying to predict the weather an hour from now is easier than predicting it next year at this time. Isn't it foolish that around the beginning of each year we see these predictions of how the markets are going to have behaved by year's end? Yet the pattern is repeated yearly. It's not enough to try to predict company earnings next quarter; Wall Street routinely attempts to predict 2015 and 2016 as well.

Most quantitative models focus instead on shorter periods. They trade day by day or week by week or month by month. This makes the methodology more responsive to what is actually occurring and allows for quicker recognition if things are going wrong so that corrective action can be taken. If you are trying to look out a year into the future, you don't know whether you are right or wrong until you are near the end of that year. Until then it's easy to say about a losing position, "Oh, we have plenty of time. It will come back."

So if you want to avoid falling for illusions, while taking advantage of the ingenuity of their creators, ask a couple of questions when you hear about good financial results:

  1. Are they founded on a rules-based approach or, instead, the cumulative results of an investment committee or other human experts?
  2. Have the rules been consistently applied over a very long time period that encompasses bull, bear, and sideways markets; and
  3. How often does it trade? Is it often enough to be responsive to the market being traded and to tell if the underlying assumptions were right or wrong?

Simple questions, but they will help you put the odds of success on your side in choosing among investment strategies. The results of quantitative strategies need not be illusions, nor should you follow the spiritual guidance of a financial medium.

Turning to last week's markets, stocks were negative across the board. Both here and abroad the arrows were pointing down last week and month to date. At the same time, quarter-to-date numbers were mixed but mostly positive in this country. Stocks of larger companies continue to do well, while small and even mid-cap stocks have suffered.

The Dollar's continued rise is largely responsible for domestically-based companies continuing to outperform their internationally-based brethren. It also is the reason why commodities continue to plunge. While gold has been the best of the commodities, it, too, has moved to an oversold condition that is the exact opposite of the Dollar's overbought condition.

Source: Bespoke Investment Group

I believe both are the result of the big move higher in interest rates of late. Investors continue to anticipate an increase in rates by the Federal Reserve. While most experts are suggesting next spring or summer, what's important is that the markets are acting like it is right around the corner.

Source: Bespoke Investment Group

Since our interest rates are already higher than most developed countries, funds are flowing into the US and our Dollar is moving higher, and commodity prices, which mostly come from overseas, are falling. And the discussion of all this creates the uncertainty that underlies most stock market declines.

Last week more economic reports beat expert prognosticators than disappointed. But this was largely ignored in the face of rising interest rates. While bullish sentiment plunged, it has not yet reached the level that seems to spur rallies.

Source: Bespoke Investment Group

And, of course, as we have been reporting, our Political/Seasonality Index has been in negative territory since September 9th. It doesn't turn positive for any appreciable time until October 9th (it does move back into stocks for the next couple of days though).

Houdini's war on spiritualists continued until the day he died here in Detroit and was carried on by his wife, Bess, for the remaining seventeen years of her life. Many thought that Houdini hated the spiritualists that he was always able to expose. In truth, he revealed to his intimates that he yearned to find the real deal.

Isn't that what drives all of us? But just as there really is no magic bullet, there is no expert that is always right or strategy that only goes up and never goes down.

In real life we learn, instead, to put the probabilities on our side. If you do that consistently or employ methodologies that do so, experience tells us that while we won't always be right, we will be right more often than not, and success will not be merely an illusion.

All the best,