By Lee Meddin, Founder and CIO of Sagacious Capital LLC
Although it is seemingly impossible to predict when fear and greed will propel markets to irrational levels, the corrections that inevitably follow are themselves predictably rational. Thus, rather than trying to predict when irrational bubbles will form, it makes much more sense to assess when they’ve already formed, and then seek to profit from the pending correction. Although identifying such situations is no easy task, the application of behavioral finance theory to global markets utilizing econometric analysis presents a unique approach to identify and potentially profit from such opportunities. This is accomplished, in part, by utilizing time series analysis to understand the historical relationship between market price and intrinsic value, and then identifying those markets globally where the relationship between these two variables deviates significantly from its long-term trend. To implement such a strategy, it is important to have first-hand on-the-ground experience in the countries in which one invests as it enables one to better understand what may be driving such deviations, and whether a specific country is indeed a suitable candidate for a long or short position. The highly specialized knowledge and experience required to implement such a strategy may seem an impediment, but it’s actually what helps to create the opportunity, as otherwise one may argue that “everyone” would already be doing it.
Market Inefficiencies Create Opportunity
Although some ardent proponents of the Efficient Market Hypothesis (EMH) say it isn’t possible to beat the market because markets are efficient, the reality is that even Eugene Fama, who was awarded the 2013 Nobel Prize for his pioneering work on EMH in the 1960s, did not hypothesize that markets are fully efficient. EMH stipulates only that markets are informationally efficient, which means that prices reflect all available information. An informationally efficient market need not be efficient in all ways.
Behavioral economists, including Daniel Kahneman and Richard Thaler who were awarded Nobel Prizes in 2002 and 2017, respectively, attribute the inefficiencies, or imperfections, in markets to errors in human reasoning. Ideally, investors would be rational at all times, but the reality is that people have cognitive biases that often lead to irrational behavior. On a large scale, cognitive biases such as groupthink and herd behavior can, and do, lead to market bubbles and crashes. Although economic theory helps us to understand why such inefficiencies exist, it does not help us to understand when such market mispricings may occur, as such events are deemed to be unpredictable.
This unpredictable nature of the market may appear to bring only risk, but it brings opportunity as well. Following bouts of excessive investor optimism and pessimism, resulting in over- and undervalued markets, there tends to be corrections that result as euphoria and despondency wane and investors return to more rational decision making. Thus, even though we can’t predict when investor irrationality will prevail, by being able to identify when it is present, one can position their portfolio to take advantage of the potential correction.
Identifying Opportunities by Quantifying Investor Sentiment
When assessing whether a market is under- or overvalued, one is really making an assessment as to whether the current market price is cheap or expensive relative to what they perceive the intrinsic value to be. Theoretically, in an informationally efficient market comprised of rational investors, market price and intrinsic value would always be the same. However, as a result of cognitive biases, they often differ. This manifests itself as investor sentiment.
Utilizing investor sentiment in an investment strategy involves buying and selling when large discrepancies exist between market price and intrinsic value. However, unlike traditional value investing, which is based primarily on fundamental analysis, incorporating investor sentiment into the investment strategy requires more of an econometric approach. By utilizing time series analysis to understand the historical relationship between market price and intrinsic value, one can identify when the relationship between these two variables deviates significantly from its long-term trend.
One useful metric to assess relative intrinsic value is the aggregate multiple of earnings that investors are willing to pay to acquire stocks. This is the price-to-earnings (PE) ratio that many investors are familiar with. However, to be meaningful, one needs to use normalized earnings in the ratio, rather than current earnings. One reason for this adjustment is that at the bottom of an economic cycle, earnings tend to be at their lowest, and as earnings are in the denominator of the PE ratio, this may result in an artificially high multiple, making the market appear overvalued when in fact it may be an ideal time to buy. The reverse is also true.
Although there are many ways to estimate normalized earnings, inclusive of adjusting for cyclicality, as advocated by Nobel Laureate Robert Shiller, all are subjective. Thus, one should not rely solely on price-to-earnings to assess relative intrinsic value of the market. Other metrics are required, such as the ratio of market capitalization-to-GDP. This is a favorite of Warren Buffett who’s stated that “it’s probably the best measure of where valuations stand at any given moment.” This ratio is similar to the PE ratio, but uses gross domestic product (GDP) in lieu of aggregate corporate earnings in the denominator. Whereas earnings capture only the net income of the publicly traded private sector, and tend to exhibit punctuated periods of volatility, GDP is a broad measure of everything produced within a given country and tends to be more stable. Understanding these differences, and incorporating both in the analysis, paints a more complete picture. Analysis of additional macroeconomic time series and fundamental data sets goes even further towards allowing one to better assess relative market value.
As corporate earnings, GDP, and market capitalization are all measures of an economy, one may expect them to move in relative unison. For many countries, this is indeed the case and in statistical terms this can be expressed as the regressions of price-to-earnings and market capitalization-to-GDP having a high r-squared. For such countries, investor sentiment can be quantified in statistical terms as the deviation in market price from that predicted by its long-term trend with corporate earnings and GDP. Large deviations, representative of bouts of extreme pessimism and optimism, often create buying and selling opportunities.
The Importance of a Global Portfolio
In extreme instances, such as during the heights of the dot-com bubble in the late 1990s and during the depths of the global financial crisis in 2008 and early 2009, such deviations are relatively easy to identify using the appropriate data and analytics. However, in the majority of cases, identifying the most opportune time to buy or sell is not so easy. For this reason, implementing such a strategy in only one country would be impractical. There are bound to be long intervals in which the deviation is not enough to signal either a buy or sell opportunity and sitting on the sidelines during these periods would most likely lead to underperformance.
However, for the majority of investors, the reality is that their investment universe is the global market. If one is willing to look broadly enough, at any given time there are likely to be a number of countries that are significantly under- or overvalued. By choosing to buy the most undervalued countries and/or sell the most overvalued countries, a portfolio can be created where one has the potential to profit as the historical relationship between market price and intrinsic value in these countries reverts to its historical mean. Additionally, by creating a portfolio that includes both long positions in undervalued countries and short positions in overvalued countries, the risk that markets globally continue to become even more irrational can be somewhat mitigated.
Inherent in a global portfolio is currency risk. Fortunately, in many countries where investors demonstrate excessive optimism or pessimism, this affects not only the equity market but also the currency market. Such positive correlation presents opportunity for unhedged positions, as a long unhedged position stands to benefit as excessive pessimism recedes, potentially leading to a recovery in both the equity and currency markets. Likewise, a short unhedged position would benefit if excessive optimism were to ebb, potentially leading to a decline in both the equity and currency markets back to their trend values. To the degree that the portfolio contains both long and short positions, and the currency correlation among these positions is high, this helps to mitigate the overall currency risk in the portfolio as a change in one currency value may be offset by another. Additionally, there is always the opportunity to actively manage currency risk in a global portfolio.
The fundamentals on which this strategy is built are not unique. What is unique is the incorporation of an econometric approach to quantify consumer sentiment and the application of this to a global portfolio. Implementation of this strategy requires, among other things, an understanding of econometrics, quantitative finance, global markets, fundamental analysis, behavioral finance, macroeconomics, and geopolitics. It also requires the ability to develop analytics that tie all of this together. In addition to this theoretical knowledge, having first-hand on-the-ground experience with those countries in the investable universe creates an edge as it enables one to better understand the specific factors that affect the investment climate in each country. It is actually this unique combination of knowledge and on-the-ground experience in a multitude of countries that create the opportunity. After all, it is not only having the ability to think differently that creates an edge, but equally importantly, the unique ability to implement.
About the Author
Lee Meddin (Lee@sagaciouscapital.com) is the Founder and CIO of Sagacious Capital LLC. Sagacious Capital is a Registered Investment Advisor (RIA) offering separately managed accounts that follow a global macro investment strategy. Lee began his career in 1989 as a control systems engineer in the oil & gas industry, developing pipeline leak detection systems for Shell Oil’s offshore platforms in Alaska. In 1993, he joined First Chicago’s derivatives trading desk in London, and in 1997, he joined ABN AMRO’s debt capital markets desk in Singapore, responsible for fixed income structuring throughout Asia. In 2000, Lee joined the World Bank Group in Washington, as Global Head of Structured Finance for the International Finance Corporation (IFC), the private sector arm of the World Bank. Later, he served as Deputy Treasurer, where he helped to optimize the management of IFC’s $80 billion balance sheet. Following this career where he structured and invested in transactions in over 60 countries and over 40 currencies, Lee founded Sagacious Capital LLC as a vehicle to translate this experience into a global macro strategy that could be offered to investors. Lee has a Bachelor of Science in Mechanical Engineering from Tulane University and an MBA from the University of Michigan. He is also a CFA® charterholder.
The foregoing content reflects the opinions of Sagacious Capital LLC and is subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or construed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct.
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