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A Few Notes on Reading Minds and Markets

| | Posted in: Big Ideas

In his 2009 book, Reading Minds and Markets: Minimizing Risk and Maximizing Returns in a Volatile Global Marketplace, author Jack Ablin, Chief Investment Officer for Harris Private Bank, seeks “to help individual investors gain a foothold in a fiercely competitive investment marketplace… My own approach to doing this is not a get-rich-quick scheme… To successfully outperform the market over the long term…, you need to learn how to read the market’s mind, to figure out where the risk and rewards are most acute at any given point in time… I use the model and the tools I describe in this book every day of the week. …I show you exactly how to do so…” The principal messages of the book are:

Chapter 2 advocates viewing the market at a higher level than individual securities.

“What is needed is an investment approach that understands valuations for market indexes, each of which contain hundreds or sometimes even thousands of different stocks, bonds, or other securities. This kind of big-picture, or ‘macro’ investment strategy, is at once more inviting and more statistically robust for investors trying to capture some incremental returns… Macro-level investing means investors focusing on industry groups, sectors, or asset classes.”

“It all boils down to active asset allocation: the ability to identify when it is time to increase your exposure to stocks, bonds, commodities, or real estate. The key to success is devising an investment process that regularly evaluates markets in an attempt to identify areas that are overpriced and risky as well as those that contain hidden value.”

“And the first step to build that decision-making process is understanding the need to insulate yourself from the human flaw that is most dangerous of all to any investor: You must find a way to be sure that you don’t let emotions like greed and fear replace cold, hard logic…”

Chapter 3 asserts the difficulty of competing at the individual security level for individual investors.

“So what is an investor’s edge in this kind of Darwinian struggle? A significant part of it lies in the investor acknowledging that he or she is at a disadvantage when it comes to trying to pick the best-performing stocks… As an independent investor, your ‘added edge’ can be your ability to pick markets.”

Chapter 4 emphasizes the benefits of investing at the macro (versus individual security) level.

“You can certainly employ stock selection as part of a global-macro approach. The issue is really a matter of time and effort because if you can get market selection right, then successful investing can be achieved with substantially fewer critical decisions. …I’ve come to accept that there is no way I can consistently deliver top-quality risk-adjusted returns to my investors without adhering to a rigid global macro investment discipline as part of my strategy.”

“The key to a rational investment process is to minimize the opportunities for our weaknesses to show themselves. A global macro decision-making process accomplishes this because it requires making fewer decisions and so creates fewer opportunities to be distracted. At the same time, each decision is likely to make a bigger difference to a portfolio.”

Chapter 5 discusses metrics as tools for investment management.

“The underlying principle behind financial metrics isn’t very different from that governing the operations of a car’s dashboard. Instead of relying on a series of data points to help me drive safely, I’m counting on different metrics to tell me what is happening in the financial markets.”

Chapter 6 identifies the five key categories of metrics (factors) for implementing a global macro investing strategy.

“…[F]ive factors need to be considered by anyone hoping to develop a process that is both robust and successful. Collectively, valuation, the economy, liquidity, investor psychology, and momentum explain and shape a good deal of the major movements within financial markets. The weight of any single factor might vary from time to time, but investors who make their market selections based on all five factors are likely to end up with a stronger portfolio, one characterized by higher returns and lower risk levels… But those evaluations should be made with a 12- to 18-month investment horizon.”

Chapters 7-11 address the five five factors, one by one:

“Trends dominate financial markets, and momentum shapes those trends. …it’s the momentum factor that will tell you about the timing of a correction or rebound.”

“…[T]he crucial economic metrics, the ones that tell me whether it’s time to shun or embrace U.S. stocks, are the shapes of two different curves. One is the yield curve… The second is the ‘federal funds’ futures curve… A steep yield curve…signals strong economic growth. …The steeper the [federal funds futures curve], the greater the likelihood that interest rates will be higher in the future, creating a headwind that companies must confront. …the logical next step is to look abroad in search of a region where the economy is expanding…”

“…[Y]ield [credit] spreads turn out to be the metric that is most useful in understanding liquidity in the financial system… Wider spreads consistently signal that…liquidity is constrained.”

“None of the [sentiment] indicators…should be used in isolation… Ideally, you should monitor what is happening with all these metrics and look for a point when they all seem to be generally in agreement… But the biggest mistake you can make is to automatically be a contrarian.”

“‘Relative valuation’ is the single most important criterion in determining how you will separate the most attractive markets from the ones that are only mildly interesting and those that are downright unattractive. …The most crucial ‘fundamental’ metric proved to be the earnings yield model [Fed Model], thanks to its ability to help me calculate the relative merits of stocks and bonds at any given point in time. …A useful way to put the P/E ratio to work…is to track the relative P/Es of one market compared to another over a period of time.”

Chapter 12 offers a synthesis.

“…[A]lthough I can give you the tools and even some hints about how to design the right kind of plan, ultimately the final decisions are in your hands. This is the point at which investing becomes as much of an art as it is a science. …the key to strategic thinking is a kind of sixth sense that would be added to these five factors. Only time and a greater familiarity with the metrics that comes from using them will tell you when it’s time to ignore what one factor appears to be signaling, when to emphasize what another set of metrics is telling you, or when you need to give a greater weight than you have historically to another factor. …Repeatedly, valuation and momentum emerge as the most important of these five factors…”

Some critiques of the book are as follows:

The data and analyses offered to support selection and use of the five factors (and their associated metrics) are generally not rigorous. Nor does the book crisply address model asset class allocations.

Research on the value of many investor sentiment measures (cited via links above) does not support a belief that they are key metrics.

The synthesis in Chapter 12 seems vague and conflicted, counseling discipline but ultimately punting with “as much of an art as it is a science” and an essential “sixth sense.”

In summary, Reading Minds and Markets offers an interesting perspective on what matters most in allocating funds to asset classes, but falls short of some other sources in terms of rigor and specificity.

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