Works Both Ways

Mor­gan Housel has a blog post called “100 Lit­tle Ideas”. It’s a list of con­cepts from dif­fer­ent fields that help explain how the world works, and num­ber 52 on the list is ‘Feed­back Loops’.

“Falling stock prices scare peo­ple, which cause them to sell, which makes prices fall, which scares more peo­ple, which caus­es more peo­ple to sell, and so on. Works both ways.”

We cap­ture this in QAV with our three-point trend lines. The check­list might turn up a com­pa­ny with ter­rif­ic look­ing num­bers, but if the chart is head­ing in the wrong direc­tion, there’s not much sense buy­ing into it until it turns around. We could get killed by a neg­a­tive feed­back loop.

You’ll hear peo­ple say that mar­kets are ratio­nal because every­thing is known and priced in. The flaw in that the­o­ry is that mar­kets are made of humans.… and humans aren’t ratio­nal. If I was ratio­nal, I would­n’t be mak­ing his­to­ry pod­casts for a liv­ing. I’d get a real job.

Daniel Kah­ne­man put it about as plain­ly as it can be put in Think­ing, Fast and Slow. Every time a share changes hands, one per­son is buy­ing and anoth­er is sell­ing, at the same price, on the same day, with the same pub­lic infor­ma­tion sit­ting in front of both of them. Both can’t be right.

“The puz­zle is why buy­ers and sell­ers alike think that the cur­rent price is wrong. What makes them believe they know more about what the price should be than the mar­ket does? For most of them, that belief is an illu­sion.”

I guess both can be ratio­nal, mak­ing the best deci­sion they can based on the data they have and their oper­at­ing the­sis for the stock. But they obvi­ous­ly think they know bet­ter than the mar­ket. As do we — so does that make us irra­tional? Or just more con­fi­dent in our mod­el?

You might think ama­teurs pan­ic and the pro­fes­sion­als sit there con­fi­dent­ly hoover­ing up what­ev­er the ama­teurs dump… but I debunked the val­ue of con­fi­dence in a recent arti­cle.

A few weeks ago I wrote about Richards Heuer’s Psy­chol­o­gy of Intel­li­gence Analy­sis and those eight horser­ace hand­i­cap­pers who were giv­en more and more data about each race. Their accu­ra­cy did­n’t move. Their con­fi­dence climbed the whole way. On five pieces of infor­ma­tion their con­fi­dence was rough­ly cal­i­brat­ed to how well they were actu­al­ly doing. By forty they were bad­ly over­con­fi­dent. The clin­i­cal psy­chol­o­gists did the same thing, and so did the doc­tors. Being a pro­fes­sion­al does­n’t exempt you from that. More screens and more data buy you con­vic­tion rather than accu­ra­cy, and con­vic­tion is the fuel a feed­back loop runs on. You might look busy. You might feel busy. But you’re still wrong.

Our three point trend lines also lever­age the upside of pos­i­tive feed­back loops. There’s a well-known paper from the Jour­nal of Finance in 1990 argu­ing that, when enough peo­ple are trad­ing on price direc­tion rather than val­ue, the ratio­nal move for a sophis­ti­cat­ed investor is to get in front of them, buy ear­ly and ride it. That’s why our check­list gives an extra point if there’s a new three point upturn. Of course, we’re only buy­ing a stock if it stacks up well enough on oth­er met­rics to have a strong QAV score, we’re not just trad­ing on sen­ti­ment alone.

The clean­est demon­stra­tion of the pow­er of feed­back loops is cryp­to, which we have talked about a lot on the show. Our fun­da­men­tal issue is that no-one can tell you what a sin­gle Bit­coin is worth. There’s no cash flow to dis­count, no assets to count, no earn­ings to mul­ti­ply. There is no ratio­nal mod­el avail­able for work­ing out whether today’s price sits above or below intrin­sic val­ue, because there’s noth­ing to mod­el.

And yet the price moves vio­lent­ly, up, down, based pure­ly on feed­back loops, noth­ing else.

It works at the lev­el of an entire mar­ket, too. On the 19th of Octo­ber 1987 the Dow fell 508 points in a sin­gle ses­sion, 22.6%. The Fed­er­al Reserve’s own his­to­ry of the crash describes the mech­a­nism in one sen­tence: “An ini­tial price decline starts a vicious cir­cle by caus­ing port­fo­lio insur­ers to sell, caus­ing fur­ther price declines, caus­ing port­fo­lio insur­ers to sell again, and so on.” The offi­cial inquiry, the Brady Report, called it “a self-rein­forc­ing con­ta­gion of fear”.

We see it hap­pen on a small­er scale all of the time when a stock goes ex-div­i­dend. The price will drop as peo­ple who were hold­ing out for the div­i­dend sell their hold­ings. But then the price con­tin­ues to drop, well below the val­ue of the div­i­dend. Why? Feed­back loops. The price is falling so peo­ple (and algo­rithms) sell. It’s easy for an investor to get caught up in the emo­tion and the pan­ic.

Which is why our trend lines exist.

The check­list tells us if a busi­ness con­tains a good bal­ance of qual­i­ty and val­ue. It has noth­ing to say about what sev­er­al thou­sand oth­er peo­ple are going to do with the share price over the next few months. Some of them are sell­ing because the chart looks bad. Some of them are buy­ing because the chart looks good. Whether that’s ratio­nal or not does­n’t much mat­ter, because they both affect our invest­ment.

The trend lines recog­nise group­think, but they also allow for the pos­si­bil­i­ty that a stock falling despite good num­bers on paper might be falling for per­fect­ly ratio­nal rea­sons that we’re sim­ply not aware of, because we’re not experts in that com­pa­ny or its sec­tor or what its com­peti­tors are up to.

And we don’t want to be experts. We don’t have to be. We’re experts at using the sys­tem. That, as it turns out, is enough.

The sell line tells us the mar­ket has turned pes­simistic on a stock, right­ly or wrong­ly. The buy line tells us there’s enough sup­port behind it that the mar­ket isn’t reject­ing the the­sis. Nei­ther one is a fore­cast. They’re a read­ing of where things stand today.

Works both ways.

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QAV Myth Killers is a week­ly col­umn in the QAV newslet­ter, tak­ing apart a piece of
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