Lazy Man and Money

Finding a Pattern Where There Isn’t One

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I was reading the new Money Magazine the other day and found the article on Warren Buffett very interesting. Unfortunately it was of the few articles that I found interesting. This is unusual for Money Magazine – I still consider it some of the best money I spend each month.

I love psychology and I think it greatly impacts how we invest. As humans we have a lot of strengths and weaknesses. When it comes to recognizing patterns, we are particularly good. Sometimes it is as if we are almost too good and want to find patterns when there aren’t any. I think we do this to try to make sense of a world that is full of random events (I apologize to the fate-believers, I’m just not with you.).

Turns out this belief in false patterns has a name: Apophenia. (I can’t decide if it sounds more like a Greek Goddess or a very short-lived Godfather character.) Sometimes it is called “patternicity” which I like a little better.

All of this shot into my brain when I saw this image in Money’s Buffett article:

Sometimes There is No Pattern
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I encourage you to click it for a larger version.

This image shows that if you simply invested evenly in all ticker symbols starting with the letters W-A-R-R-E-N, you would have handily whopped the S&P 500 over the 20 years.

The article explains why this has worked over the 20 years. Smaller companies have done better than larger ones and investing them equally gives them a greater weighing than the S&P 500. The S&P 500 consists of larger companies and doesn’t have the small companies at all.

If someone didn’t know any better, they might say, “Hey this is clearly a pattern showing you how to beat the market.” Hopefully we are smart enough to know that there really isn’t anything special with ticker symbols starting with the letters that spell W-A-R-R-E-N.

This reminds me a little of the funny website spurious correlations that helps us understand correlation does not imply causation. My favorite chart on that website is the correlation of divorce rate in Maine to the US Per capita consumption of margarine.

However, what happens in a scenario where the pattern isn’t so arbitrary? I think that’s where things get difficult for a lot of people, professionals included. If the chart didn’t use the ticker symbol gimmick and instead with something like return on small companies when equally weighed, it presumably (from the article’s explanation) would show a similar trouncing of the S&P 500 over the last 20 years. That would lead one to believe that such investing is the clearly the way to go. There’s no kooky red flag to tell us, “This pattern is crazy.” It’s hard to determine what is causation and what is correlation in a complex system like the stock market.

What does this all mean? I wish I had a super conclusion to wrap it all together. Unfortunately, I do not. What I do have is the thought that diversification is even more important than I thought it was.

How Expensive Are Stocks Now?

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From around 1999 to 2001, I dabbled in a little day trading. I wasn’t make many trades a day, but I probably averaged somewhere between 50 and 100 a year. It was the complete opposite of the buy and hold strategy that I largely hold today. During that era, I learned a lot about technical analysis of the stock market. With a tiny amount of pride, I can say that I forgotten most of it. Hopefully that space in my head can be used with something a little more worthwhile.

A few weeks ago, I wrote an article New Nonsensical Stock Trading Idea: Someone Else Paid A Lot More For It, where the commenter, correctly, called me out for marketing timing. I think the discussion that took place was one of the most interesting in the 6 years I’ve been writing Lazy Man and Money and highly recommend reading it. Today, I’d like to focus on just one small part of that conversation.

In the course of the discussion, I had made the case that I think with the Dow Jones Industrial Average (DJIA) up around 13,000 stocks looked expensive. My rational was that except for a short time in 2007 the DJIA hadn’t rarely been above 13,000 and it barely crossed 14,000 before dropping and then getting hit by the banking collapse in late 2008. Clearly once again, the DJIA is getting too expensive, right?

Wrong.

I love to be proven wrong as it gives me an opportunity to learn. This is a case where I learned a lot.

Where did I go wrong? I looked at absolute numbers, like Dow 13,000, and not the math behind them.

The commenter, Jim, had pointed out that the S&P 500 was actually very cheap when you look at its price relative to its earnings. Jim showed the graph:

S&P 500 Price Earnings

where it looks like the price-to-earnings ratio is around 13, which is historically fairly low indicating that stocks in general are not expensive. However, if you were looking for a cheap time to buy into stocks, like say the beginning of 2009, when the Dow had dropped to around the 7,000 range, this chart wouldn’t be very helpful.

It’s at that point that I started to look into this in a little more detail. I found that there is something called the Shiller P/E (yes same Robert Schiller mentioned here: Buying a Vacation/Retirement Home (Part 5)) that is does seem to spike during these blips of historically cheap times to buy. Here’s a telling chart from Multpl.com:

Schiller P/E 10 chart

That chart might be a little small, but hopefully you can make the peaks at the 1991, 2001, and 2008 market drops.

It’s worth noting that the chart isn’t currently screaming that it’s time to buy like on the other big dips.

Using the two charts, my admitted amateur opinion is that stocks are fairy cheap, but that they aren’t screaming deals that they’ve been a few times in the last 20+ years.

The bigger lesson here is to not look at absolute numbers. It was something that I had known for a long time, but had simply forgotten. It’s a strong reminder to me that every now and again it is wise to go back to the basics.