Bulls and Bears

Source TheLanguageLab

It seems counter intuitive that indexing a portfolio can outperform very smart people who spend enormous resources analyzing company specific information, macroeconomic data, charts of price and volume history, and even sunspots. After all, in many aspects of life, those who are most talented and work the hardest get ahead. But apparently not so in the investment world, with the exception of those who work hard at studying and understanding the evidence.

Studying the evidence over many periods and from different perspectives leads to the conclusion that most managers will underperform the market after costs, whether they try to market time, pick the best stocks or funds, or use a technical approach.  Furthermore, even those who outperform over a given period do not persist in their out performance. In a practical sense, trying to pick the best performing funds on the basis of track record is futile. Morningstar demonstrated this by picking mutual funds for its 401(k) fund that underperformed on an aggregate basis.

How is this counter intuitive finding explained?  There is a whole literature that goes into this; but, from a very basic standpoint, it goes back to the notion of a market transaction.  At any point in time, the bulls and bears are evened out.

First, think about a simple economic transaction where I sell my calculator to you for $50.  The transaction means that you value the calculator for more than $50 and I value it at less than $50.  This is the essence of a market.  The same type of transaction takes place in the stock market.  When I sell 100 shares of Microsoft for $25.10/share, I believe it is worth less and the buyer believes it is worth more.  There is a difference here, however.   One of us will be wrong. .

Ramp this up to the portfolio level, and go one step further and consider market views.  Here are some views presently held:

Ralph Acampora   technician... market headed higher to challenge year's high by year end
      main idea:  VIX (primary measure of market anxiety) is high; and each time it has been this high, the market has been significantly higher 4 months  later. (DIY Comment:  Let's jump in!)

David Rosenberg  economist ...stocks headed sharply lower...main idea:  market does not appreciate how weak the economic data is...we are headed for recession... need to look at 3-month average when looking at data to even out the revisions and short term influences. (DIY Comment:  Whoa...maybe we had better hold off.)

Jay Feuerstein  CIO 2100 Xenon...Dow Jones Industrial Average headed for 8200...main idea:  GDP without Government is negative and global economy weaker than perceived. (DIY comment:  Yikes!)

Jamie Dimon CEO JP MOrgan Chase & Co....Market headed sharply higher...main idea:  companies ready to "rock and roll" once governments get out of the way, including Europe...companies have cash and much improved capital structures. (DIY comment:  Good luck lessening the influence of the government - especially with elections around the corner...note to self - send Mr. Dimon link to recent Republican candidate debate.)

Obviously, some prognosticators will look brilliant as we move into 2012 and others will look bad.  All are very smart and convincing.  All probably have their portfolios positioned to conform with their beliefs.

All of the above applies as well to sectors and individual stocks.  Again, it is in the nature of a simple transaction.