Can This Simple Trading System ‘Beat the Stock Market’?

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Russian television caught up with us yesterday. They wanted to do an interview. It would only take a few minutes. And the questions — shown to us in advance — were about the global monetary system.

But on camera, the interviewer had a surprise:

Do you agree that sanctions against Russia are hurting the world economy?’

Well, of course,’ we replied. ‘Anything that interferes with markets and trade will hurt an economy. After all, it was the Smoot-Hawley Tariff — which raised tariffs on imports — that was partly responsible for the depth of the Great Depression.’

We might have added that hurting the economy was the whole purpose of the program. Sanctions and war are rare forms of government action: ones that set out to do harm…and succeed. Other programs promise to do good…and make matters worse.

Always in doubt


When we left you last week we were beginning to explore a difficult subject: the limitations of knowledge…and how you can invest intelligently in a world of ignorance.

We also promised a reward: a simple trading system virtually, practically, almost guaranteed to work.

When a new government program is announced we can never know what the seen and unseen consequences will be. Similar programs may have failed 100 times before, but this time may be different.

Similarly, in the investment world, we never know what will happen…or why it happens. Still, we have to make our guesses. Sometimes right. Sometimes wrong. And if we’re smart, we’re always in doubt.

But some things are more likely than others. If you put your money on housing in 2007 because ‘housing never goes down’, you were betting on something that may have been true. Then again, it may not have been. You were in danger of losing money when the truth was known.

And today, if someone tells you ‘housing never goes down’, you are advised to bet against it, because recent experience tells us that that hypothesis is definitely not true.

Historically, markets swing back and forth but are anchored in some ‘normal’ range.

Large-cap US stocks, for example, tend to trade between 10 times earnings and 20 times earnings. Occasionally, they are more expensive. Sometimes they are less.

When they are more than 20 times earnings, buyers typically have a hypothesis that justifies the higher prices. ‘This time it is different,’ the sentence begins, followed by ‘because…’

We can never know that this hypothesis is true. We may know from experience that similar hypotheses have been proven false. But we can’t be sure that this one will be disproven too.

But as the price of stocks rise, the potential reward for betting against the extraordinary new hypothesis goes up. We don’t know at what point a short position represents good value for the money, but it must be there somewhere.

As a round-number guess, we will say it comes at 20 times earnings. Any time the P/E of the stock market goes over 20, you are probably best advised to get out.

Likewise, the same thing happens on the downside. At a certain point, investors think it is the end of the world…or simply ‘The Death of Equities’, as BusinessWeek famously put it on its front cover in August 1979, right before one of the biggest bull markets in US stock market history.

Then investors sell stocks too cheaply, based on an unproven hypothesis. Most often, the end of the world doesn’t happen. And stocks go back up.

Again, we can’t know at what point it makes sense to bet against the ‘end of the world’ hypothesis. So we’ll stick with another round number and say 10 times earnings.

Now what do we have? We have a trading system that will knock your socks off!

Are markets efficient?


But let us go back and put this in perspective…

In the 1960s a number of academic researchers — led by Eugene Fama, Michael Jensen and Richard Roll at the University of Chicago — won fame and fortune with their Efficient Market Hypothesis by showing that market prices reflect all publicly available information and that trading systems of any sort were a waste of time.

Investors, said the proponents of efficient markets, all had access to the same information known about companies, profits, the economy, the state of the world — everything. And markets were amazingly successful at rapidly reflecting this publicly available information.

Therefore, there was no way to consistently get an edge over the market without taking on extra risk. An individual may think a particular company is underpriced or overpriced, but he could not know more than all investors put together, so his opinion was just one of many. Aggregated opinions determined the market price; there was no better way to determine what a stock was worth.

It stood to reason, then, that any investment performance that ‘beat the market’ was just luck. And that, over time, luck would run out…and returns would regress to the mean. Warren Buffett famously took on these efficient-market proponents in 1984, in a debate at Columbia University.

Representing the EMH crowd was Michael Jensen, then at the University of Rochester. Samuel Lee of Morningstar recalls the event:

Jensen starts. He reviews the academic literature, reciting a litany of studies showing no statistically significant evidence of skill. It sounds impressive. (I’m filling in the details here; it seems no copies of his speech survive on the Internet.) He ends by describing the fund industry as a coin-flipping game – enough coin-flippers and someone’s bound to enjoy a long streak that in isolation looks impossible.

Buffett responds. He asks you to imagine a national coin-flipping competition with all 225 million Americans. Each morning the participants call out heads or tails. If they’re wrong, they drop out. After 20 days 215 coin-flippers will have called 20 coin flips in a row – literally a one in a million phenomenon for each individual flipper, but an expected outcome given the number of participants. Then he asks, what if 40 of those coin-flippers came from one place, say, Omaha? That’s no chance. Something’s going on there.

Buffett argues "Graham-and-Doddsville" is just that place. He presents nine different funds that have beaten the market averages over long periods, all sharing only two qualities: a value strategy and a personal connection to Buffett. He emphasizes that they weren’t cherry-picked with the benefit of hindsight.

In closing, he boldly predicts that "those who read their Graham and Dodd will continue to prosper." The crowd goes wild. Later on, at the cocktail reception, everyone’s talking about how Buffett crushed Jensen.

Buffett went on to rub it in by beating the stock market for the next 27 years. From 1985 to 2012, his Berkshire Hathaway’s book value went up 18% per year, more than twice the 7.4% annualized rise of the S&P 500. In the process, Buffett became, for a time, the world’s richest man.

Yes, Warren Buffett beat the market — and not by accident.

But can you?

More tomorrow…on why investing is a ‘loser’s game’ and how you can pick up the dollar that isn’t supposed to be there.

Regards,

Bill Bonner
For The Daily Reckoning Australia

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Bill Bonner

Bill Bonner

Best-selling investment author Bill Bonner is the founder and president of Agora Publishing, one of the world's most successful consumer newsletter companies. Owner of both Fleet Street Publications and MoneyWeek magazine in the UK, he is also author of the free daily e-mail The Daily Reckoning.
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