Quant Mashup - Philosophical Economics Profit Margins, Bayes’ Theorem, and the Dangers of Overconfidence [Philosophical Economics]It’s the fall of 2011. Investors are caught up in fears of another 2008-style financial crisis, this time arising out of schisms in the Eurozone. The S&P 500 is trading at 1200, the same price it traded at in 1998, roughly 13 years earlier, despite the fact that its earnings today are almost(...) Speculation in a Truth Chamber [Philosophical Economics]In this piece, I’m going to share a mental exercise that we can use to increase the truthfulness of our thinking. The exercise is intended primarily for traders and investors, given their obvious (financial) reasons for wanting to think more truthfully about the world, but it has the potential to(...) Diversification, Adaptation, and Stock Market Valuation [Philosophical Economics]Looking back at asset class performance over the course of market history, we notice a hierarchy of excess returns. Small caps generated excess returns over broad equities, which generated excess returns over corporate bonds, which generated excess returns over treasury bonds, which generated excess(...) The Paradox of Active Management [Philosophical Economics]In this piece, I’m going to introduce a simple market model, and then use the model to illustrate certain important concepts in the debate between active and passive management. Some of these concepts have already been discussed in prior pieces, others are going to be new to this piece. Consider,(...) The Value of Active Management: A Journey Into Indexville [Philosophical Economics]The increasing popularity of index investing forces us to ask the following questions: What necessary functions does active management perform in a financial system? What is the optimal amount of active management to have in such a system, to ensure that those functions are carried out? If the size(...) The Impact of Index Investing [Philosophical Economics]The prior piece received a much stronger reaction than I expected. The topic is complicated, with ideas that are difficult to adequately express in words, so I’m going use this piece as a follow-up. I’m going to look at the specific example of the Tech Bubble, which is a clear case in which the(...) Index Investing Makes Markets and Economies More Efficient [Philosophical Economics]U.S. equity index funds have grown dramatically in recent decades, from a negligible $500MM in assets in the early 1980s to a staggering $4T today. The consensus view in the investment community is that this growth is unsustainable. Indexing, after all, is a form of free-riding, and a market can(...) In Search of the Perfect Recession Indicator [Philosophical Economics]Given the downturn in the energy sector and the persistent economic weakness abroad, investors have become increasingly focused on the possibility of a U.S. recession. In this piece, I’m going to examine a historically powerful indicator that would seem to rule out that possibility, at least for(...) Growth and Trend: A Simple, Powerful Technique for Timing the Stock Market [Philosophical Economics]Suppose that you had the magical ability to foresee turns in the business cycle before they happened. As an investor, what would you do with that ability? Presumably, you would use it to time the stock market. You would sell equities in advance of recessions, and buy them back in advance of(...) Trend Following In Financial Markets: A Comprehensive Backtest [Philosophical Economics]“My metric for everything I look at is the 200-day moving average of closing prices. I’ve seen too many things go to zero, stocks and commodities. The whole trick in investing is: ‘How do I keep from losing everything?’ If you use the 200-day moving average rule, then you get out. You play(...) The Impact of Taxes on Investor Returns [Philosophical Economics]If you had invested $100,000 in Altria Group ($MO) on March 31st, 1980, the position today, with dividends reinvested, would be worth $93.6MM–a 21.0% annualized return. If you had invested the same amount in Berkshire Hathaway ($BRK-A), the position would be worth $77.0MM–a 20.4% annualized(...) Momentum: Slip Counterfactuals, the "Stale Price" Effect, and the Future [Philosophical Economics]The recent piece on the dangers of backtesting has attracted an unusual amount of attention for a piece on this blog. I'd like to thank everyone who read and shared the piece, and also those who offered up commentary on it. To be clear, my intent in presenting the Daily Momentum example was not(...) Financial Backtesting: A Cautionary Tale [Philosophical Economics]Consider the following market timing strategy, which we’ll call “daily momentum”: (1) If the market’s total return for the day, measured from yesterday’s close to today’s close, is positive, then buy the market at today’s close and hold for one day. (2) If the market’s total return(...) The Trajectory of a Crash [Philosophical Economics]It’s amazing to think that just last Monday, August 17th, the S&P 500 closed at 2102. Today, it closed at 1868, falling 11.1% in 6 trading days. The shocking speed of the decline has injected a level of fear into markets not scene since the fall of 2011, when the Eurozone debt crisis was(...) Capital Recycling at Elevated Valuations: A Historical Simulation [Philosophical Economics]Those who expect U.S. equities to deliver poor returns going forward can cite two compelling reasons in defense of their expectation: (1) Equity prices are significantly elevated relative to underlying earnings fundamentals. The S&P 500′s trailing price-to-earnings ratio, for example, is 20.5(...) A New-and-Improved Shiller CAPE: Solving the Dividend Payout Ratio Problem [Philosophical Economics]A common criticism of Professor Robert Shiller’s famous CAPE measure of stock market valuation is that it fails to correct for the effects of secular changes in the dividend payout ratio. Dividend payout ratios for U.S. companies are lower now than they used to be, with a greater share of U.S.(...) Using Total Return EPS to Decompose Historical S&P 500 Performance: Charts from 1871 to 2015 [Philosophical Economics]In this piece, I’m going to do six things: First, I’m going to clarify the purpose of Total Return EPS, what it’s trying to accomplish–a topic that probably wasn’t addressed as clearly as it could have been in the prior piece. In a single sentence, the purpose of Total Return EPS is to(...) Janitor to Multimillionaire? Not In This Market [Philosophical Economics]Last week, CNBC profiled the inspirational story of Ronald Read, a gas station attendant and janitor from Vermont who amassed an $8MM fortune simply by investing portions of his small salary into high-quality, dividend-paying U.S. equities. Given the sampling of names that Read is reported to have(...)