Foggy Market Hypothesis

I think Cullen Roche has hit the nail on the head when he said that an asset’s risk is very difficult to compare relative to one another. This is a very important point. Take for example, if you invest by sectors and have to choose a selection of companies. You would quickly realise that there are many different types of risks, even for companies operating in the same sector, or even with almost identical businesses.

Volatility is a less relevant factor than the risk of product sales and product pipeline. A small company almost wholly dedicated to providing hardware to Samsung would have its fate (and share price) tied up to the demand from Samsung. It may be argued that the lumpy contracts are reflected in the swings of the share price, but this is not always so. Giving a different example, misleading management (Tesco!) or in the extreme outright fraud (Enron) can wipe out your investment completely. Normal volatility measures cannot account for this very binary risk but this risk is embedded in the asset price. “Trust-worthiness” is a measure that the industry sub-consciously add to the valuation but is still not theoretically acknowledged.

And, what is defined as risk for a particular asset to one investor may not be the same as to another investor. This non-homogeneity of definition when valuing an asset and the difficulty of quantifying or putting a number to the risk factors make the price of an asset susceptible to speculation, rumours and tips more than it should be. Considering the equation Value = CF/(r-g) where CF is current cash flow (which is updated periodically), g the growth rate and r the discount rate, ‘g’ can be seen as the least certain and ‘r’ as the speculative risk bit that moves the price the most day-to-day even when there are no news at all on the company.

Analyst reports with their extreme variation in opinions for some names and almost mind-boggling herd mentality on some other names are not much help either in identifying and measuring the risks involved. Alright, maybe that’s too harsh. But all these idealised agents of  the market, investors, analysts and fund managers, are assumed to have perfect knowledge and frictionless trading costs, which, borrowing Roche’s expression, is entirely “bollocks”.

Academics usually work in Universities first, churning out abstract papers, then migrate to financial companies in search of different challenges and better pay. Perhaps it would be a revolution for the Finance discipline if we have a whole army of would be academics work in the industry first, before  testing out various market theories. Take Cliff Asness for example: what would his first research as an academic be? If you notice, his writings have markedly different views than those accepted in the academia.

And this is a very good paragraph from Roche, I think:

This presents us with a different conundrum though.  If no one really understands the risks they’re undertaking when they put money to work in the markets then how are the assets being priced efficiently so that good risk adjusted returns are hard to come by?  One would assume the assets aren’t actually being priced “right” or efficiently.  Instead, they’re being priced wrong.  But that doesn’t make the market easy to predict.  After all, this misunderstanding actually means that markets are hard to predict because everyone is working with such an imprecise and different set of understandings that one must also be able to predict when and how those participants are mispricing assets (in addition to assuming that those same irrational participants will one day price the assets the way YOU think they should).

I’ve added the bold for emphasis. There is still a lot of scope and in my view, a pressing demand for a greater role and application of information theory in finance to industry models.

I’m still pondering over the validity of this statement from him, though:

It’s the stupidity of the crowd that often makes it so difficult to make money in the markets.

I’m guessing the situation is not as dire as “stupid”, more like…….. “foggy”.

Josh Brown has a piece saying similar things here.




Leave a Reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s