Even the Best Market Methods Don’t Work All the Time

Successful methods are often victims of their own success in short-term perspective. Long-term alpha could be sustained only if it is arbitraged in short-term perspective.

What is an arbitrage in most simple terms? You know how when you are in big traffic, one of the lines next to yours appear to be moving faster. The odds are that you are not the only one on the road that notices that. At the very same moment you decide to switch to the faster line, there will be a bunch of other people who have made the same decision and also move. It is uncanny how similarly we humans think in certain situations. As a consequence, the faster line will lose its edge. The odds are that people who stayed in their original line are likely to progress faster than the ones that switched lines. This is how arbitrage on the road works. It might seem worth it in short-term perspective, but it hardly earns you anything in long-term perspective.

Despite the common human factor, financial markets are way more complicated systems than traffic and often a “line” could remain faster much longer than expected, but not forever or in the words of Keynes – “the market could remain irrational longer than you can remain solvent”. The involvement of money tends to drastically change human behavior.

How does arbitrage work with value market approaches

Let’s say that buying stocks, trading under 10 times last year’s operating profits and with zero LT debt, has proven to be an extremely profitable approach over time. The exceptional return that it has generated will attract more and more capital. It is not hard to realize that if more and more people/funds use this approach, there will be less and less stocks that will meet the criteria – the very moment a stock drops near 10 times operating earnings, it will be snapped back. As a result, the overall alpha of that approach will gradually evaporate. The signals that the system produces will be very few are rare, and only occur after fear-driven forced market liquidations, meaning that those who have to show results in a couple of quarters, might be out of luck, depending on their timing. As more people move to other strategies, that same strategy will go back to its original returns that made it popular at first place. And the cycle will start all over again.

Most people won’t stick to the same method, either because they are impatient themselves or their clients are.

In the first case, “the grass of our neighbors is greener” syndrome plays a huge role. Many investors live with Einstein’s words: “the definition of insanity is trying the same approach over and over again and expecting the same result” and like to constantly switch strategies. Einstein’s thesis is true only if the environment does not change. In reality, if you apply the same approach in the market over and over again, you will get different results for the simple reason that the market environment constantly changes; but note that it changes in repeatable cyclical patterns.

Investors love to send money to work to managers that appear “hot”, despite the extensive evidence that this approach leads to subpar returns. When you deal with other people’s money, you have about two quarters to be right, unless you have earned their trust. There is only way to earn investors’ trust – by initially making them a lot of money. Call it luck, call it proper timing of the fund’s launch, but good initial performance could win you more time to be right before your investors pull their money and go chase someone or something else. Not only do you need to deliver, but you also need to appear busy, because for some peculiar reason inactivity in money management is often associated with laziness.

Or as Joel Greenblat eloquently summarizes:

Value investing doesn’t always work. The market doesn’t always agree with you. Over time, value is roughly the way the market prices stocks, but over the short term, which sometimes can be as long as two or three years, there are periods when it doesn’t work. And that is a very good thing. The fact that our value approach doesn’t work over periods of time is precisely the reason why it continues to work over the long term.

How does the arbitrage process work with momentum approaches

First of all, there are countless ways to integrate momentum in your equity selection approach, but they all fall in one of these two groups:
– making new high of some sort: 52week high, 3yr highs, all-time highs or 50-day high for shorter-term duration.
– Relative strength: it outperformed the the majority of the rest of the stocks over certain period (6 months being the most frequently used)

What happens more and more people notice that buying momentum works. Well, naturally more and more money is attracted to this market approach – more money buys that 52week high and the group of stocks with the highest 6-month RS. Not only the new capital put to work doesn’t arbitrage the gains over time, but it even make them bigger and quicker. Nothing last forever though. When for some reason the “fear of losing” becomes bigger than the fear of missing, a commonplace correction take place. And then all of a sudden, a commonplace market correction comes and not only almost all breakouts to new 52-week highs are faded, but some of the highest RS stocks become juicy short targets and experience deep 40-70% cuts in a few months. Momentum stocks stop to deliver and investors start to question the viability of the approach. After awhile, almost no one wants to touch them anymore and the next “sure” in the market is chased after.

Safety in markets is derived from proper timing. Knowing when your investing approach works best…priceless.

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