Pockets of Predictability
According to Economyths by David Orrell, the theory of complex systems shows that such systems are generally unpredictable, but can have “pockets of predictability”. I read the book some time ago, but this idea has stayed with me, because I think that it applies very well to markets. I do not know very much about complex systems theory, so it may be that my use of the idea is a direct application of the formal notion or it may be that it is an analogy; since I have found it useful, I don’t really mind which it is.
I think that markets are generally not predictable, but that they can have pockets of predictability. Further, I think these pockets come in two types, which I like to call “pockets in space” (actually, in the space of recurring market inefficiencies) and “pockets in time”. Pockets in space are persistent features of the market — for example, the propensity of commodity markets to trend, or of stocks that score well on value metrics to outperform. Pockets in time are macro changes, actions by the authorities, and so on, that create a temporary directional predictability, such as the combination of the switch from a tightening bias by the ECB and the worsening of the euro crisis last year, which made the direction of EUR/USD temporarily predictable. In order to understand my trading method, it is important to understand that, while most actors in the market are trying to trade pockets in space, I mostly trade pockets in time.
Let me give two examples of people who exploit pockets in space: stock-pickers and systematic trend-followers. A stock-picker is likely to be someone who has learned his trade from another stock-picker. He applies an investment methodology in the belief that stocks that meet his criteria will outperform the market over time. Sometimes it works, and sometimes it doesn’t, but he hopes that it will work on average across a portfolio and over long periods. His success is dependent upon the continued existence of a pocket in space, and it is this that, at root, he is betting on. Similarly, a systematic trend-follower might combine a number of different strategies and employ a number of quantitative analysts to better exploit various kinds of market trend, but he too is, at bottom, betting on the continuation of the same kind of trending behaviour as has happened in the past, on average across various different markets and over long periods. Many other investment styles make similar bets on the continued existence of pockets in space.
I mostly trade pockets in time. An important aspect of what I wanted to learn about the markets when I set out to trade them was how to make money in a way that was not dependent on the market environment. In the language of this piece, although I did not use it at the time, I did not want to be dependent on a pocket in space. The 2008 crisis demonstrated that a business based on pockets in space can be highly vulnerable to their temporary or permanent disappearance; to be achieve long-term success, one needs a fundamentally unfounded belief that one’s chosen pocket will exit in the long term, the good luck to find that it actually does exist in the long term and cast-iron investors who will not pull the plug in response to short-term variation. Warren Buffett has had this combination of belief, luck and quality investors; many others have been considerably less fortunate.
By trading pockets in time — that is, by going into markets only when I have reason to think that events have made their future direction unusually predictable — I am not reliant on the long-term persistence of some particular feature of the market. Of course, I do need certain assumptions: that markets change slowly enough for me to understand what is going on, that their behaviour should be coherent with the rest of reality (e.g. if the price is at X before some salient change, it should not return to X after it), that the system is not so complex that it is impossible for a human being ever to grasp, and so on. But my assumptions are more fundamental, and thus less shaky, than those of Mr. Buffett and his many lesser competitors.
The distinction between pockets in space and pockets in time is useful in elucidating the problem that Great Northern faces in its selection of opportunities in general, and of equities in particular. Great Northern evaluates investments on a stand-alone basis. This means that it does not make sense for us to attempt to exploit pockets in space: even if the pocket exists and its effect is felt over our investment horizon, random variation means that our small number of positions may not benefit from it. That observation renders irrelevant much of our knowledge — both received and internally generated — about what features to look for in individual stocks in order to build an outperforming equity portfolio, which is an exercise in exploiting a pocket in space. As I see it, the great problem with which we are constantly grappling is how to identify a pocket in time, in the market for an individual equity, that will allow us to make our target return.
The Never-Ending Story
The ECB looks to be moving closer to taking a haircut on its Greek bonds that will see it make a small profit (since it bought at a discount to par).
Yesterday I mentioned the incentive faced by Greek politicians to appear to fight for Greece before capitulating to the demands of the Troika. The reality of that incentive is affirmed by the latest opinion poll from Public Issue, which has New Democracy, which has been noisy on the subject, leading PASOK by 31% to 8%. ND’s support has held up as PASOK’s has collapsed in recent months. This is somewhat unfair, given that ND was responsible for the dodgy accounting that precipitated the crisis, but that’s politics. Democratic Left, according to neoskosmos.com the most moderate of Greece’s left-wing parties, is now ahead of Pasok.
There are signs that Greeks may be turning against the European solution to their problems. Having enjoyed a large positive approval rating when he took power in November, Papademos has seen them fall by 5%. It is true that Greeks still approve of him overall, 62% do not trust him to manage the country’s economic problems, compared to 35% in November, according to a January poll from Public Issue. Yet this does not seem to be translating into an increase in support for the relatively intransigent ND.
Demography of Unemployment
Calculated Risk reports on a note from Goldman Sachs (http://bit.ly/yLqSOh) that points out that the latest census found more workers in the young and old age brackets and fewer in the middle than had been expected. Because the young and the old have lower labour-force participation rates than the middle, this is likely to depress the labour force participation rate statistics through 2012. CR argues that this will have a positive effect on the unemployment rate — presumably because the number of people assumed to be looking for work will be lower for any given set of establishment survey responses (I am not clear on exactly how the new population controls will flow through the stats).
Bloomberg reported that Japan had the lowest current account surplus for fifteen years, presumably referring to the annual figure (mom the surplus rose). The reason was energy imports, because most of Japan’s nuclear reactors are shut down. The shutdown was a classic system 1 response — the recent nuclear disaster sticks in our memory, and the availability heuristic leads us to overestimate the probability of another, similar disaster. Objectively, discovering that a nuclear reactor was not immune to being shaken about and dunked in the sea is akin to an Apple engineer finding that the iPhone was not immune to being put through a washing machine. He might have tried to make it as tough as possible in order to withstand reasonable shocks, but it would not be surprising to discover that he had overlooked some weakness that would lead the phone to break under such stress. How likely is it that any of Japan’s other reactors will suffer a combined shaking-and-dunking before the weaknesses that happen to have been identified this time around can be fixed? Not very. How likely is it that any human creation can be made completely immune to shaking-and-dunking? Not very.
- Consumer Credit 19.3bn b.e. and fell a little, Dec. Looking inside the numbers, consumers have turned to their credit cards. This is a the second very high monthly consumer credit number.
- Japan current account surplus increased, b.e., Dec.
- German trade surplus fell a little but remained high, Dec.
Next 24 Hours
- Crude inventories
- Japan core machinery orders
- China CPI and PPI
- UK manufacturing production and IP
- UK trade balance