LINQCRED: A Hedge Fund Manager
Yesterday we revealed our disciplined approach to interpreting information. It is actually quite simple, but we already have some complaints. Too complicated. Too many steps.
Investors and traders who want to gain a real edge must be willing to do a little work. This is a good test. If you are not willing to employ a careful process of critical thinking when evaluating information, you should just buy an index fund and move on. Those who are willing to do the work can beat the market by several points each year.
Learning by Example
The best way to learn — and really learn right — is to study examples until you get them all right. Earnings season is a great time to do this. There is plenty of anecdotal evidence and interpretation. We read and analyze them all, but this series of articles will try to provide some illustrations from varying perspectives.
Background: Observers and Data Analysis
One of the most important aspects in interpreting information is understanding the expertise of the observer. At "A Dash" we like to look outside the investment world to help readers see the point. Then we come back to an investment application.
The Numbers Guy has a great article on streaks in baseball. This is a worthy topic for another day, but we were struck by the following comment on one of the most astute baseball analysts, Tim McCarver:
Streakiness and momentum aren’t the only tenets of conventional
baseball wisdom to collide with math. Fox analyst Tim McCarver
expressed surprise during the Red Sox-Indians series upon learning that
multirun innings are more likely when the leadoff batter hits a home
run than when he walks. His assumption was that a runner on base
affects the pitcher and batters psychologically, leading to a rally and
multiple runs, while a leadoff home run makes everyone start with a
clean slate. But the numbers show that it’s easier to get one more run
with the bases empty, than getting two runs when starting with a runner
on first base. Mike Kellermann, a Harvard graduate student, rounded up
the reaction from blogs and showed that historical numbers side with
the homer. Meanwhile, sports-statistics company Stats Inc. told me that
in the 2007 regular season leadoff home runs led to multirun innings
28.4% of the time, compared to 27.2% of the time for leadoff walks.
The point: Impressions, even by the best experts, are inferior to analysis of the data.
Example: A Good Hedge Fund Manager
Erin Burnett, who is asking opinions about recession of anyone in front of the microphone, interviewed a good hedge fund manager in one of CNBC’s new segments yesterday morning. There is no point in naming the manager, a very sharp and engaging man who embarked on a trading career right out of college, and who now has his own fund. We know many people just like him, and believe his perception and approach to be quite typical.
The key question and answer were as follows:
EB: You can sit here
and argue persuasively for a recession or against a recession —-
RS: A lot of the
evidence that argues against the recession is backward-looking and a lot of the
evidence that argues in favor of it is forward looking. Until we get more data it’s going to be hard
for this to sort itself out. …Friday I
was particularly troubled by a note from JP Morgan … which downgraded Ford and GM credit
because of rising delinquencies in the prime auto market. As you start to see evidence that this is
expanding beyond the sub-prime homebuilders you have to become more and more in
the camp of recession. I’m not
optimistic that years and years of financial excess can be wiped away with a
couple of small funds and a couple of moves here and there…..we are headed
toward more difficulties.
Implementing the Method
After reading the information carefully, we readily see that it involves interpretation and analysis of information disseminated in the market last week. The novelty, step "N" in the method (LINQCRED), depends upon the interpretation of the data, not the data itself.
Turning to Qualifications, we have no idea about the success of this manager in making global macro calls of this sort. He is someone who got an interview on TV.
Turning to Competence is a crucial point. The interview subject seems to have begun with a viewpoint about the markets and market history. How does one know the extent of "financial excess" or how long it might take for this to be resolved. We have had a period of below trend growth in GDP, intended by the Fed? How much will be enough?
Most importantly, has this observer really studied what types of data are backward-looking and what data provide a leading indicator? Do rating agencies look forward or do they look back on past results? [This is rhetorical question. Rating agencies are obviously deciding on recent performance. That is past data. Is there evidence that it is predictive?]
This observer in our example has a viewpoint and reads the news carefully. In a known and planned period of reduction in economic growth, to fight inflation expectations, we see such data every day. If one begins the day by looking for it, it will be there.
Our example observer spends his day trading and running his fund. He has not done an analysis to determine which indicators lead and which do not. It is an opinion, and one that lacks face validity.
Compare this approach — typical among traders and hedge fund managers – with those who specialize in taking data from all sources to make forecasts — like the ECRI. There is a difference between those who study indicators to find those that lead, and observers who begin with an opinion.
Following the LINQCRED method carefully should warn the investor about embracing this conclusion — even if CNBC decided to feature the comments.