The Fifth Way: A Dialogue with Scott Burns
By Jesse Czelusta (from the March 2007 issue of Index Rx)
This month we offer a reply to a letter from syndicated investment columnist Scott Burns. In his letter, Mr. Burns outlined four progressively sophisticated investment positions: Magical Thinking, Belief in Basic Indexing, Smarter Indexing, and Intelligent Indexed Portfolio Management. He then asked us to fit our strategy into his schema of investing philosophies. We hope that our response will be helpful to those who want to know more about the technical rationale for the Index Rx strategy.
Thanks very much for the prompt and pithy reply. Your categorization should be required reading for anyone thinking about investing in equities. May we have permission to print your note in an upcoming issue?
To address your question in brief: The Index Rx strategy could be viewed as a form of intelligent indexed portfolio management, since we invest in both US and international issues and asset allocation is a core component of our approach. In reality, our strategy is also consistent with basic indexing and smarter indexing. In essence, we think that even over relatively long time horizons, fundamentals are only as important as those who move markets think they are. We agree with your assessments, but we see a deeper reason for their veracity, a reason with important implications for investors.
To expound a bit: We adhere to a fifth basic investment position, a philosophy that incorporates all three of the latter views (and partially explains Magical Thinking). Let's call it "Cliometric Index Investing." To borrow terminology, we see ourselves as intransigent agnostics swimming in an ocean of zealots and snake oil salesmen. Our personal opinions regarding price movements do not enter our investment decisions. Our motto is "Do what everyone else does before most of them do it." Because we use only index funds, because we trade infrequently, and because our strategy is completely mechanical, we are essentially couch potatoes with a high tech remote control for selecting index funds from across the globe and for mid-term market timing.
To explore more fully: Our "remote control's" core technology is a theory known as "rational beliefs." Rational belief theory is a powerful, rigorous, and revolutionary upgrade of rational expectations theory, the latter being the foundation of efficient markets theory and also, therefore, of pure indexing ideology. In short, rational belief theory holds that it is impossible to know the Investment Truth. Instead, people can arrive at different conclusions using exactly the same information. Individuals may hold any opinion that is not contradicted by existing fact. The theory of rational beliefs provides a framework for understanding economic decision making and equilibrium dynamics that is much more realistic than the narrower theory of rational expectations. Academics have yet to fully operationalize this notion, and this is perhaps why rational belief theory is still unfamiliar ground, even among economists.
For investors, the central practical implication of rational belief theory is that fundamentals in and of themselves are irrelevant; markets are moved by the aggregation of many divergent, yet partially correlated opinions. Because investors' opinions are correlated (what one person thinks is affected by what other people think), patterns arise in market data that reflect these correlations. For instance, we believe that human nature is captive to fear, greed, and peer influence.This leads to consistent over-and under-reaction on the part of investors to focal points in the information spectrum. This is likely the reason that valuation levels matter (in the sense that they are correlated with price movements).
If I may pause for a minute to re-emphasize-- In our view, valuations predict price movements not because they are measures of future profits relative to current price. Instead, valuations matter because they reflect the aggregation of investors' sentiments about particular stocks. Because sentiment over-and under-reacts, a stock with a low (high) valuation will be more likely to rise (fall).
Perhaps more importantly, direction predicts direction. A stock that starts on it's way down (up) will likely continue to fall (rise) for the near- to mid-term as investors update their beliefs. The alternative hypothesis is that valuations matter because they measure stocks' inherent worth; but if this were the case, no stock would ever be over- or under-valued because investors would instantly snatch up (or dump) stocks with low (or high) valuations. (I've never seen a twenty dollar bill on a Vegas sidewalk, but I've seen lots of other scraps of paper scattered across Sin City's concrete.)
In the long run, of course, any stock's price is a function of profits. Yet the distance between now and the long-run is filled with multiple births, college educations, and retirements. Furthermore, we can't predict future profits. But, if we are able to identify patterns in the data (in valuations or currency markets or inflation, perhaps; but in an array of other market indicators as well), we can to a degree predict what most other people will believe about future profits within specific sectors and for the market as a whole. Thus, using valuations to predict price movements is just one application of rational belief theory. And if you believe that valuations matter, you almost by definition must believe in market timing, since the overall level of the stock market is (over the near- to mid-term) as much a function of aggregate valuation levels as it is a function of profits.
The Index Rx strategy has by no means identified the full range of potential market patterns. Instead, we have crafted a strategy that capitalizes on a small set of these patterns in a way that minimizes trading while still allowing us to benefit from knowledge of these patterns. We feel that there is still much work to be done in this area (as evidenced by the research that you reference on valuations).
Our motivation in creating the Index Rx technical models had nothing to do with the publishing business, we simply wanted a better way to manage our own investments. We were nauseous from ingesting too much snake oil, yet knew better than to think too highly of our own investment opinions. Thus, we wanted a completely mechanical strategy that required almost no time or thought to implement and at the same time cut out as many Wall Street middlemen as possible. We've chosen to apply them to index and exchange trade funds for all of the well established reasons.
After five years of investing his own savings in portfolios dictated by these models, my father noticed that he was doing quite well and had outperformed every mutual fund newsletter tracked by Hulbert Financial Digest. Since then (November 1999), we've been crusading against snake oil via Index Rx. We've managed to build a loyal subscriber base and to weather one of the worst downturns in stock market history with remarkably minimal losses, given that our models have a decidedly bullish bent.
Thank you again for your informed response. Your time and thought are greatly appreciated.