MODEL-BASED INVESTING IS DOOMED
Investing is not a science. Markets reflect emotions and expectations of millions of participants and should therefore give relatively reliable signals of what’s in store for the economy. Rising or declining markets may not always be justified, but any adjustments to ‘fair value’ will always follow, sooner or later. That’s why superior investors and traders have developed their feelings over time, for the perils and powers of intuition.
Model-based investing, however, purports to be more accurate, as it removes emotion from investment decisions. It would expand an investor’s scope in order to minimize the chance of being blindsided. There are limits to the amount of information an investor can meaningfully absorb at any point in time, but a model’s capabilities would seemingly be endless. Some models even proclaim, that they incorporate intuition, without being overly reliant on the processing of data (‘data mining’)!
One of the widely used models is the outrageously flawed ‘Fed Model’: this compares bond yields and the earnings yield, the inverse of the Price/Earnings Ratio. But why would it make any sense to compare fixed nominal bond yields to wildly fluctuating earnings of risk assets? Any model can work for awhile, until it doesn’t! This model gave a strong Buy signal for equities in 2008, before the Crash, and a strong Sell signal at the bottom in 2009! That’s why a ‘scientific’ approach to investing is so risky. Only the dangerously complacent or naive could assume, that model-based investing is the answer to successful investment performance. And yet, it seems, that trillions of assets are being managed this way. No surprise, then, that such an approach is simply asking for trouble.
Selling Bonds at these low yields may look like a no-brainer, but yields keep going lower. Similarly, Stocks keep going higher, despite the relatively miserable economy. What else should companies do than buying back their own stock? The long-term prospects for capital spending remain too uncertain. However, these decisions are based on deeply flawed mathematical models, which, by the way, also gave the ‘green light’ before the Great Financial Crisis.
RICK SCHMULL
July 21st, 2014
WESTCLIFF-On-SEA, ESSEX, U.K.
