The Art of Risk Consulting
(April 28, 2005)
Dear Subscribers and Readers,
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All right, let's get to the heart of this commentary. In a way, our website and I are risk consultants. I have no trouble thinking in these terms - since as many of my subscribers know, I am also a full-time actuarial consultant during the time I don't have my market cap (no pun intended) on (which is very difficult, especially during trading hours). My life revolves around numbers, even though I also love to write and speak to an audience. I am also a "big picture" guy and like to be aware of (or figure out) all the current economic and societal trends (whether I do a good job of it is left to the judgment of our subscribers) that are important to our subscribers personally or to the stock/financial markets. Being able to write this commentary and helping our readers along the way is the perfect job for me and is, in essence, a dream true. Somehow, I was in the right place at the right time.
The difficult part when it comes to risk consulting is measuring the type or the sources of risks that are not measurable using traditional metrics. Actuaries can usually quantify everyday risk (such as the number of car accidents in a certain city in a given year) but they cannot guard against a 1906-style San Francisco Earthquake or a horrible event like September 11th. Such risks are unquantifiable in the traditional sense. Warren Buffett mentioned that most insurance companies have not guarded themselves against "a 100-year flood" while Berkshire Hathaway has. As we all know, Warren Buffett is one smart investor - he does not wait for evidence to show itself before making the necessary preparations. By then, it will be too late.
Similarly, such risks are risks that businesses face everyday. For example, I just got the latest print issue of MIT's "Technology Review" in the mail today. I have subscribed for six months now and I can say that I genuinely like it - they are very much ahead of the trend and do a very good job in keeping pace and giving us in-depth discussions of the most important topics. For example, these guys wrote an article on the fight in the search market between Google and Microsoft two months ago - well ahead of the Fortune cover story on Google and Microsoft that only "broke" a week ago (and I thought "Technology Review" did a better job in bring the important issues to the table). Anyway, the latest cover story is titled "10 Emerging Technologies" - with the list being airborne networks, quantum wires (featuring Dr. Richard Smalley, a Nobel Prize winner at my former school), silicon photonics, metabolomics, magnetic-resonance, universal memory, bacterial factories, enviromatics, cell-phone viruses, and biomechatronics. For readers who are interested in reading about these technologies, you can do so here. I had no idea what half of the technologies on the list were before I read the articles but after finishing them, I was convinced that these were the up and coming technologies. And then I ask myself: Is it really that simple?
Often, the success of certain technologies is easier to predict. If a certain technology or idea offers bright prospects up ahead, then usually it will stick - even though many adopters of the technology or idea wound up going away. The PC was one example, and the companies that adopted the internet as the central part of their business model was a classic - not unlike the many railroads or car companies that went busy in the mid 1800s and early 1900s, respectively. Predicting the success of individual companies that adopt such technologies or ideas is easier said than done. For example, who doesn't know that "all you had to do to get rich" was invest in Dell or Starbucks 10 years ago? Or Microsoft in the late 1980s or Yahoo after the IPO in 1996? Sure, emerging technologies and ideas are perhaps easier to predict, but who could forget ISDN or global satellite phones (Iridium and Globalstar, for example)? What happened with the widespread adoption of nuclear power or fuel cells that use hydrogen as its source of power? The Dell direct sales model was an innovative concept, but who could've imagined it will get so hot - aided by the advent of the internet in the late 1990s? Even so, what if you had invested in Gateway or Emachines instead of Dell? Or an investment in Metricom before the idea of wireless hot spots really took off? Coincidentally, in the same issue of "Technology Review" is an article about Transmeta, fittingly entitled "A Breakthrough Isn't Enough." The article starts off with the following:
THE CASE: Transmeta, which was to have been a market-grabbing pioneer in low-power microprocessors, is in tatters. Its failure serves as a cautionary tale to companies long on innovation and short on execution.
Consider that the company raised money from both Paul Allen and George Soros. Sure, Paul Allen has been known for making not-so-wise investments in the telecom and cable industries, but George Soros - I would say - has a pretty darn good track record. Suddenly, Warren Buffett doesn't sound like an investment know-nothing that fails to "get with the times" after all, does it? No, Warren Buffett is the ultimate risk assessor. He is a great numbers guy and has an excellent grasp of actuarial mathematics and statistics, but at the same time, he is also a great assessor of risks that are unquantifiable. How does he do that? Does he have "insider information?" No. How about a crystal ball into the future? Hardly. So how does Warren Buffett (or George Soros) do it?
It is said that when Warren Buffett invests in a company, he researches the heck out of it and gives himself a big "margin of safety." That way, if something goes wrong at the company, the price that he bought at should be sufficiently cheap now such that he wouldn't take a huge hit. That is why valuations have always been so important to him. At the same time, he also researches the heck out of the management at the company. In fact, he has often mentioned that the integrity of the management is nearly always the most important factors when it comes to buying a company or shares of the company. George Soros, in the meantime, was unlike most of his peers in the investment industry. Soros has often argued that the markets are really inefficient more often times than not, and that booms and busts cycles happen more often than the Wall Street or the academic models predict. In his investments or speculations, he would go out of his way to seek such situations, such as capitalizing on the rising of the commodity bull cycle in the 1960s or betting that the dollar pegs will fail in many of the Asian countries during the 1997 Asian Crisis. That is, he actively sought to profit in the tail-end of the distribution, claiming that those tail-ends are actually "fat enough" to produce many opportunities in his investing lifetime. He coined his theory "reflexivity" - which, by the way, is another case of a promising idea or theory that had failed to catch on with the mainstream economic press.
As for myself, how do I play my role of a risk consultant? I look at a lot of things - such as newspapers, magazines, periodicals, and even (sometimes the most helpful) anecdotal stories. I remember my coworkers thinking it was funny when I told them the market would crash in early 2000 because a lot of people (and my grandfather who was a very financially conservative guy) opening stock and trading accounts. I also look at a lot of technical, leading, and sentiment indicators, since the stories in the mainstream news articles have most probably already been reflected in market prices (in fact, they can sometimes act as contrarian indicators, such as the IBM article that appeared on Business Week a few weeks ago right before the price of IBM tanked). Most importantly, I look at a lot of financial and stock market history, and how various cycles and events can be used to help me with the current markets. Technical and sentiment indicators are great, but they should be interpreted differently depending where you are in the current stock market or business cycle. I also try to see the big picture and how they will affect our readings going forward - such as the rise of China, globalization, and emerging technologies/trends (such as outsourcing) that will pave the way for great changes ahead. Compared to actuarial mathematics, all this is not easy (although it is definitely much more fun).
Like I have discussed before, analyzing the stock market requires one to try to weigh all the possible events and assign probabilities to each event happening. Sometimes that is important, but sometimes not. There are just many things that one cannot really tell, even though one may be thinking it is a train wreck waiting to happen. For example, on a P/E ratio basis, the U.S. stock market was already overvalued as early as 1996. Same with the Japanese stock market throughout the late 1980s. Fortunately, one does not have to be able to gaze into a crystal ball for warning signs. Remember the record low yield spreads (throughout the junk bond market as well as the emerging markets) that I discussed a few weeks ago? And of course, the lack of respect for risk as evident by the record low VIX? And my continuous (probably annoying to some of you) discussions about the breakdown of the Philadelphia Bank Index? In such scenarios, it really does not take much to burst the bubble, so to speak. Same with the markets in early 2000. The market was priced for perfection. Is perfection a reality? Most probably not - at these junctures, it does not take a genius to figure out that one should just get out and sit on the sidelines - of course, unless your friends were taunting you for sitting on cash while they were getting a double, triple, or quadruple on stocks such as CRA, ICGE, HGSI, QCOM, and BVSN.
So what do I currently see in the stock market? I am bearish - that is no secret. However, I am not blind and I am always on the lookout for things that may change my mind and make my turn bullish. I look at many indicators but let's turn to the ARMS Index and see what has been going on with it lately. Following is a chart of the 10-day and 21-day moving average of the NYSE ARMS Index vs. the daily action of the Dow Jones Industrials:
I believe Don Hays of www.haysadvisory.com was precisely looking for a reading of 1.3 or over on the 10 DMA of the ARMS Index in order to confirm a stock market bottom in his latest commentaries. If we do bottom here, then it will be a classic bottom - notice that the 10 DMA of the ARMS Index just hit the downtrending resistance line going back to late March of 2004. If the ARMS Index penetrates this resistance line in the coming weeks, then watch out below.
My guess is that even a reading of 1.311 here is not high enough to indicate a significant bottom. A short-term one maybe, but not a tradable one and certainly not one where you can buy and hold. At the same time, I noticed that the latest bulls-bears% differential in the AAII survey declined slightly to negative 5% while the bulls-bears% differential in the Investors Intelligence survey also declined to 14.3%. Given the extremely oversold readings of the AAII survey experienced in the last four weeks, we may very well get a ST bottom here, although I would still like to see a sub-10% reading in the Investors Intelligence Survey before we would consider going long in our DJIA Timing System.
Like I said, I am not blind to the bearish side - for readers who are currently short, I encourage you to read the latest article from Mark Hulbert - which discusses the extremely oversold readings that he is now getting in his HSNSI sentiment indicator. A ST bottom should be here quite soon, but whether we will get there when the DJIA is 10,000 or 9,500 I do not know. For now, all my indicators are still signaling "beware" including for traders who are currently sitting very comfortably on their short positions.
Henry K. To, CFA
P.S. The latest edition of Business Week has a great article about the issue of blogging and how companies should or are dealing with this latest media and sentiment tool. I encourage my readers to grab a copy and read the article. What interested me was not the fact that bloggers helped uncovered the truth behind President's Bush National Guard records, but the fact that various companies are now thinking of ways to keep track of fashions, fads, and sentiment by monitoring blogs. The article discusses that at some point in the future, we may be able to develop software that will generate a "real-time heatmap" of the entire universe of blogs that will be able to quantify what bloggers are currently discussing and which will help companies strategize and develop new markets for their products or to weed out old ones.