Statistical Mistakes Traders Make

Just read an interesting article by Ben Inker on J Grantham web site about P/E inflation.

Since 1988, operating earnings have consistently grown to exceed GAAP net earnings, averaging 20 % since 2002. This is statistically impossible in an honest world. It gets worse. Forward operating earnings estimates average 13.5 % vs the realized 3.5 %.

Abby Cohen has stated she thinks the market is 6 – 8 % undervalued and will be made up by Christmas with an additional increase of 12 % over the next 12 months.

The Federal Reserve remains in bubble support mode. The record low risk premium indicate that risk is a quaint idea who’s time has passed.

Although I think the market is +20% overvalued, it doesn’t matter. If the wall street bubble makers want to drive the market up 15 %, they will. I think the market may be the next bubble, replacing housing.

It appears to be a dangerous time to be too bearish.

My 2 centavos.

There are good traders and not-so-good traders. And the difference between them is NOT the employment of descriptive vs inferential statistics. Because, even as you describe it, there really is no difference between them. A descriptive statistic has, implicit in it, backtesting. When I say I think the market will rise the next couple of weeks because the winners-to-losers ratio was 4-to-1 on above average volume this week I don’t have to back-test using gobs of data on a multi-processing mainframe.

“The same inferential tests that inform us of the validity of trading systems, when applied to the trader’s trading results, will answer that question.”
This seems to be saying that if the trade worked out it was a good inferential system. If not it wasn’t. Profound.

Although very dated, Karl Popper’s writings are a very lucid expanation of why we ought to state our theories clearly and how we ought to go about testing them.

Even better are his two more lucid and gripping books on how all this applies to us – The Open Society and its Enemies, and The Poverty of Historicism.

The excellent summary that heads this post also leads to the problem Popper identified of inductive versus deductive reasoning. In this case, as it applies to investment.

Popper’s preference for inductive reasoning is a preference most older investors have. It comes from closely examining individual companies and constructing a portfolio, one company at a time.

At the end, we may make some general observations about the commonalities of the successful, and indeed unsuccessful, components of the portfolio.

Yet it is only in the last 30 years that it has been thought prudent to bypass building a portfolio inductively; and, instead, to begin with a general portfolio view, and – from that – deduce the companies that will form the portfolio.

Both methods will lead to the formation of hypotheses which must then be continually tested.

However, older investors will think of modern deductive portfolio theory as an ultimately flawed attempt to simplify and neaten the usually tedious and ungainly task of finding good companies at fair value – wherever they may reside – and doing so, one company at a time.

It is probably the case that almost every good equities investor spends most time answering one simple inductive question :-

If I add or delete this company, will the portfolio’s future total returns be diminuished or increased?

To ask the question is to guarantee long hours spent analysing company returns and very few hours spent analysing the broader economic environment.

As there are not enough hours, at some point everyone will have to choose between the inductive and deductive paths.

Just wanted to add one thing about this rally as the markets near their yearly highs.

Hedge funds run $1.2 trillion and they are “all in” at the moment.

So the only way they win is if nobody sells — or better yet — guys like us start buying. Well — most of us are not buying. So these hedge funds are somehow going to have to sell these tech stocks to someone — most likely each other.

It’s VERY easy to buy and show a gain.

In this new world with 7000 hedge funds (+ mutual funds) all crowded together — it’s a very different thing to sell out at the current highs and book those gains.

We shall certainly see what we shall see next week.

ari5000,

The majority of equities hedge funds are both long and short a collection of stocks; usually using some form of derivative exposure as well.

The net exposure of an equities hedge fund is often 1% to 10% of the gross exposure and the relevant risk management team will reduce the gross exposure as the net exposure rises.

The returns to equities hedge fund managers come from correctly analysing variations of arbitrage, usually by country or sector.

Given the foregoing, most equities hedge funds are unconcerned about the maket’s general direction; and very concerned about the internal arbitrage direction.

Eclectic,

Using the ROIC would probably be a better measure.

However, it’s probably true that , over the years, the main influence on a comapany’s P/E – outside of the E itself – is inflation.

Many, many years ago a simple measure of this was the Rule of 20, whereby the current headline inflation rate was added to the current P/E.

When that number went over 20, the market was said to be overvalued; when it went under 16, the market was said to be undervalued.

Outside of the contractionary earnings period during recessions, that old rule did a reasonable job of aligning relative value between periods of high – and low – inflation.

Although simple, that old rule was almost the only one that allowed a like for like comparison of values between the high inflation 70’s/part of 80’s and the low inflation 90’s/00’s.

It would have interesting if someone had done that exercise for ROIC – but they never did.

You wrote:
“What have you done to qualify or test your trading or investing strategy?”

Backtesting is not of much use, in my humble opinion. There is just too much temptation to curve fit.

I am a discretionary trader within a set of clearly defined rules. The best way to qualify my trading methodology is to trade it real time for extended periods. If it makes money, your method is good. If it doesn’t, keep fine tuning it until it does.

I think the bubble is in calling bubbles.

N’uff already.

Good lessons for all ::::

#1 there is a huge gap between market analysis and trading markets to make money.

#2 There is no relationship between being “right” and making money.

#3 While markets are not predictable people are.

#4 Anything can happen in the markets so how worthwhile is a market opinion?

#5 Having a definable game plan and following it will overcome poor analysis.

#6 I know some very rich traders but I have yet to meet a rich analyst.

#7 You should never give out market advice because readers don’t need your bad advice and they will ignore your good advice so don’t give them any advice.

#8 A correct market opinion does not answer the questions of how and when do I place a bet, when do I know I am wrong, how big is my bet in terms of dollar or percent risk, and most important how do I manage my trades when they are working.

#9 Some very smart people think the stock market is going up. Some other very smart people think the stock market is going down. Since I don’t have a clue what the stock market is going to do I totally agree with both opinions.

#10 Managing the money and more importantly managing the trade is more important than being “right”.

#11 A good trade is a trade which was entered and exited following one’s rules regardless of the dollar outcome be it a gain or a loss.

#12 Most newsletters offer both sides regarding market direction. Whichever way the market goes will then be highlighted in subsequent newsletters as if the writer new what was coming.

#13 The more negative email you receive regarding a market opinion the more you should bet.

#14 If you receive emails endorsing your view you might want to re-think your opinion.

#15 You learn very little “watching” someone else trade and you might very well harm yourself as a trader by following the advice of others. Be your own man or in one case lady!

#16 Keeping a trading diary on a daily basis will teach you how you think. Be honest and don’t edit your diary in hindsight. Again trading is not about right and wrong but it is about doing and not doing