VOL. III

1. THE NATURE OF JUDGMENT

 
 
 
 “Stock markets began as extensions of markets for other types
 of goods. For ages, merchants have gathered periodically at a
 central location to trade wares. As economies grew, so did the
 range of products on offer...so did trading in instruments of 
 credit, with buyers betting not just on current but prospective
 values.”
 
 The Wall Street Journal
  The Millennium Edition
 

To a historian, nearly all events are unique and to a large extent unpredictable, embedded as they are in a dense matrix of causes and effects. To an investor, whose task it is to discern the contour of the future, there are crucial factors. It is a matter of judgment to be able to choose which are the most relevant to the particular problem.

Securities analysis seeks to identify profitable investments. As we have earlier discussed, the relevant factors are sustainable earnings growth, soundness, and valuation.

Asset allocation is more complicated because it is also a macroeconomic decision. We have shown that some adjustments to asset allocation are possible, the decision to be based upon valuation and the catalysts of cyclical and international events, which are only somewhat predictable. Why do investors commit their capital for the long term?

The Efficacy of Institutions

Developed financial markets are both the cause and the result of good public administration. Consider how a market actually evolved. During geopolitical competition with France, the war expenditure of the English state increased from 2 million pounds per annum just prior to 1688 to 8 million pounds in 1696, a scale of expenditure that required access to the public markets. As Ertman (1997) writes, “...over a period of forty years, an interlocking system of bureaucratic administration and public finance was built up in England, held together by the triple pressures of parliamentary scrutiny, market forces, and informed public opinion.”

The investing public had a direct interest in the efficacy of public administration, and the latter in turn knew that the public could enforce this interest by disinvesting their funds. By encouraging the probity of public administration, “...investors contributed more than just their money to Britain’s military (and hence commercial) successes of the 18th century.”

The Responsibility of Market Participants

Markets do not exist in the abstract, but have the character of their participants. Globalization means the freedom to trade and invest. Although this is likely to lead to the greatest prosperity for all in the long run, it is often noted that freedom and responsibility go together. When responsibility is absent, problems are apt to occur.

Consider the issue of risk control. In market societies, the assumption of risk is usually controlled by the self-interest of lenders, who for a 1-2% spread over the cost of their funds risk their entire principal. The problems of lenders to the emerging markets were brought about by a lack of good judgment, the placement of funds into blind pools. Whether these pools were the REITs of the 70s, the S&Ls of the 80s, or local banks in the emerging markets of the 90s, the result was large scale misinvestment and subsequent distress in the financial markets once the reality of this misinvestment had become manifest.

A Democratic System of Government

The free market system transmits the forces of change throughout the globe, requiring continuous political reform at the national level. Pluralist democratic societies are not only more capable of evolution; but as Christopher Patten (1999) notes, “...liberal democracies (enjoy) the things which are customarily believed to be present in a well-governed society - stability, partnership, protection of individual rights, the absence (usually) of extreme outcomes.” The reasons for these are the rule of law and the ability of popular democracies to effect timely reforms.

Asked to write a history of the world, David Fromkin (1999) did just that, in 222 pages. A professional historian, Fromkin insists that none of the major events around which he organizes his account: the agricultural revolution, the growth of democracy, the industrial revolution, and so on were inevitable. His history, nonetheless, is a chronicle of material, and perhaps moral progress. This progress is impelled by scientific-technological innovation, a method of inquiry and a process of innovation in which the United States is particularly adept.

What emerges from Fromkin’s account is a major fact of human nature. People like to solve problems. This is the motivating principle of liberal societies, requiring of their participants a respect for the facts founded upon experience; and the reasoned judgment to know those that are the most relevant to their goals.

2. WHAT IS REALITY?

 
 
 "When you read financial statements always ask,
 'What is Reality?'"
 
  Jon Stroble
 

Investing is about reality. Since it is not a good idea to assume the contrary, then the question is how this reality might be determined. Isaiah Berlin (1996) wrote:

 
 "The ideal of all natural sciences is a system of propositions so 
 general, so clear, so comprehensive connected with each other by logical
 links so unambiguous and direct that the result resembles as closely
 as possible a deductive system, where one can travel along wholly 
  reliable, logical routes from any point on the system to any other 
 - wholly reliable because constructed a priori according to rules 
 guaranteed as in a game because they have been adopted, because it 
 has been decided to keep and not break them. The usefulness of such 
 a system - as opposed to its power or beauty - depends, of course, not 
 on its logical scope and coherence but on its applicability to 
 matters of fact."
 

The required result of all quantitative models of the stock market is accurate prediction.

The Enlightenment assumed necessity: that natural objects and also, in a branch of political theory, societies necessarily followed causal or statistical laws that could be discovered for benefit. This is also the assumption underlying almost all quantitative analyses of the stock market. As we have tried to show, a quantitative analysis of stock market phenomena can enhance understanding and therefore judgment, provided it is realized that underlying a formula, there is always set of conditions that may or may not be repeated. And that furthermore, given this set of conditions, formulas are only best estimates rather than discovered laws.

The idea that there are immutable laws applicable at all times, in all places, and to everyone was central to Western philosophy until the 19th century. Berlin (1997), an empiricist in the tradition of Mill, about the reaction to the Enlightenment:

 
 "True knowledge is direct preception of individual entities, and concepts
 are never, no matter how specific they may be, wholly adequate to the 
 fullness of the individual experience....What is real is individual, that is,
 is what is in virtue of its uniqueness, its differences from other things,
 events, thoughts, and not in virtue of what it has in common with them,
 which is all that generalising sciences seek to record." 
 

In the modern world, both views are relevant; but they are different. Booch (1994) writes:

 
 "...the algorithmic view highlights the ordering of events and the object-oriented 
 view emphasizes the agents that either cause action or are the subjects 
 upon which these operations act. However, the fact remains that we cannot 
 construct a complex system in both ways simultaneously, for they are completely
 orthogonal views. We must start decomposing a system either by algorithms or by 
 objects and then use the resulting structure as the framework for expressing the
 other perspective." 
 

If the problem is general, rather than computationally intensive like weather forecasting, an object analysis is the most appropriate. If the problem is macroeconomic, that is involving questions of tactical asset allocation or economic system behavior, a few simple formulas (as entities) can be helpful provided one also keeps in mind the crucial importance of general conditions, the actions of institutions and of other participants as relevant. Is the prediction of such a complex system's behavior possible? We believe only somewhat and only by empirical rather than by deductive methods.

Since it is a fact that civil societies are complicated, we think that macroeconomic considerations usually justify only tactical portfolio changes.

We consider companies the most significant entities, with valuation considerations relevant mainly at the extremes. Would you rather invest in a formula or in a real company?

3. HOW TO HANDLE COMPLEXITY

Consider a solved problem. Most likely this problem was solved according to the logical method of Rene Descartes who formulated a method of arriving at certain truth. In "Discourse on Method," Descartes outlined four steps to overcome doubt and error:

 1. Never accept anything as true unless there can be no reason or occasion to doubt it.

 2. Divide each difficulty encountered into as many parts as possible.

 3. Think in an orderly fashion, beginning with the things which were the simplest and easiest to understand and gradually reaching towards more complex knowledge.

 4. Make enumerations so complete that nothing was omitted.

Cartesian reasoning became the primary method of the Enlightenment; it resulted in the science and technology of the modern world. By starting with a suitable mathematical model, it should (in theory) be possible to arrive at certain knowledge in matters concerning the stock market. Apply this form of reasoning to securities selection and then to asset allocation:

Start with a model that relates the P/E that you are willing to pay for a stock  to the company's sustainable growth rate. Then use a stock screen, to select stocks according to the following criteria:

1) Choose all stocks with a historical growth rate  > X%.

2) Then choose all stocks with a P/E < Y.

Most likely a large sample of stocks chosen according to these criteria will not outperform the stock market. Result of an efficient market? Not so. A closer examination of the results will show that the individual companies will have outperformed (underperformed)  the S&P 500 due to:  

1) Industry effect.

2) Company factors, where previous uncertainties have been resolved into events.

This illustrates that when doing securities selection, more than one dimension of reasoning is necessary and that dimension is likely to be qualitative rather than quantitative. Consider, in detail, the issue of company valuation.

The theoretically correct model for determining a company's P/E ratio states:

 
 
 d 
 P/E = ____________
 (k - g)
 
 where: d = the proportion of earnings distributed
  k = the required return of the investment
 g = the rate of perpetual growth in the company's
 dividends 
 

The perpetual growth rate assumption of this model might be appropriate in some cases but not in others - particularly when evaluating companies whose expected rates of growth are high, exceeding the investor's required rate of return. As a matter of practice, infinite P/E ratios being unacceptable, this model will be modified; analysts will assume different rates of earnings growth in different time periods, etc.

Not only is judgment always necessary, a consideration of company particulars is as important as quantitative valuation. As we have shown earlier, a low stock valuation does not signal a buy unless company fundamentals are likely to improve. Conversely, a high stock valuation (within limits) does not signal a sell unless there is also a negative change in long term company fundamentals.

Securities selection, so construed, is a matter of quantitative reasoning combined with the facts and circumstances of the case. It is concerned with long term profits rather than with short term risks, which are more effectively addressed by asset allocation issues.

Consider the issue of asset allocation. On 4/28/98, we suggested that investors reduce their equity allocations to appropriate levels. We suggested this for the following reasons:

    1) On 4/28/98, the S&P 500 closed at a level of 1085. Using a measure of expected inflation and an estimate of future capacity utilization, our quantitative stock market model suggested that the stock market was more than 14% overvalued. Assuming a perfect economic environment in the future, the market was fairly valued.

    2) Many economists believe that the economy, operating at full capacity, can grow at a non-inflationary rate of only 2.5%, the sum of population and productivity growth. In the previous two quarters, the economy grew at an annual rate of around 4%. If the underlying consumer demand does not decrease, inflation could be a problem in the future. Furthermore, our index of manufactured tradable goods prices increased greatly in February and March, after decreasing in the previous two months.

    3) On 4/27, the Wall Street Journal reported that the Fed had decided upon a bias towards increasing interest rates during its March 31st Open Market Committee meeting.

We suggested that investors reduce their allocations to equities in accordance with their circumstances and risk tolerances. After some further increases, the S&P 500 decreased to 957 on 8/31/98 due to the continuing financial crisis in Asia and the effect of decreased commodity prices upon other developing economies. We were right about valuation, but wrong about the catalyst. Another reason not to do wholesale market timing. We consider allocation adjustments useful for increasing returns at the margin, not for reducing risk.

We have described the behaviors of distinct entities: companies, the Fed and inflation, and the U.S. stock market. Rather than trying to describe how they interact all at once, it is possible to choose the entities that are the most relevant to the questions being asked. The dimension of time provides a useful way of organizing this:

Shorter Term Financial System Behavior

Relevant Entities:  The U.S. Stock Market and the Fed and the International Environment

Longer Term Financial System Behavior

Relevant Entities: Companies and the International Environment

The way to handle complexity is to partition the problem into useful components, then developing the solution. This method of reasoning (Booch, 1994) can be applied to the broadest range of problems. It corresponds to the economic structure of market societies; it is also the logical structure of modern programming languages.

4. WHY COMPANIES GROW  (ref. to Vol. II & Vol. I)

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