Are You a Fox or a Hedgehog?

08/02/2012 8:15 am EST


Are you a grand thinker that has a unified model for the way the world works, or are you someone who has more than one lens to see the world? The answer may affect your portfolio, observes Samuel Lee of Morningstar ETFInvestor.

Investors who “know” that European stocks are doomed are probably fooling themselves.

University of Pennsylvania psychologist Philip Tetlock conducted a mammoth 20-year study on expert predic­tions. He found their performance modest, handily beaten by naive statistical models that used historical averages or simply extrapolated present conditions to the future. Tetlock classified experts as either “hedgehogs” or “foxes,” and compared their records.

Hedgehogs are grand thinkers who wield a universal model of how the world works. Foxes are ad-hoc and eclectic thinkers who see the world through many different lenses, never certain that any single one apprehends the truth.

Hedgehogs scored the most impressive and memorable predictions, owing to their high confidences in extreme predictions. But the diffident foxes were better overall forecasters. Unfortunately, the “experts” who appeared most frequently in the media tended to be extreme hedge­hogs, confident without good reason.
These lessons are applicable to financial markets, which are really prediction markets. How do we become more foxlike, or better yet, model-like in our investing behavior?

Don’t let confident-sounding pundits reassure you or scare you silly. Prefer simple, robust models to elaborate and vivid stories. And acknowledge that you probably don’t know as much as you think you do. To make these lessons concrete, let’s walk through three models that I believe say important and true things about the markets.

The Gordon Model
The Gordon dividend discount model answers the most important investing question: What kind of return can I reasonably expect from an investment? It can be elegantly stated as k = d + g, where k is return, d is yield, and g is the growth rate of the divi­dend. In other words, your expected return on an asset is its current yield plus the growth in per-share dividends.

The model has strong theoretical and historical foundations. It acknowledges that an asset’s intrinsic value is determined by its future cash flows.

And it’s done a good job in forecasting long-run stock market returns. It works because, in the long run, corporate earnings can grow only as fast as the economy does; otherwise, earnings would eventually make up the entire economy.

A large economy like the United States seldom experiences big fluctuations, so the stock market’s per-share dividend growth over decades-long spans is bounded by a narrow range. Over 30-year rolling windows, the S&P 500’s real dividend per share growth has averaged about 1% from 1900 to 2011, with a standard deviation of 1%.

Note that per-share dividend growth lagged real GDP growth by 2% annu­alized. The gap reflects capitalism’s creative destruc­tion: Current shareholders are diluted away by new companies springing into being and established ones issuing new shares.

Plugging in the historical per-share real divi­dend growth rate (1%) and adding an extra term for net share buybacks (0.5%), the model suggests that Europe’s long-run after-inflation expected return is 6% annualized (4.5% yield + 1.5% real per-share divi-dend growth). This beats out the US’ 3.5% expected return (2.0% yield + 1.5% real per-share dividend growth). Sensibly, investors demand a higher expected return to invest in sclerotic, about-to-fly-apart Europe.

Most markets display mean reversion, the tendency for beaten-down assets to outperform over the long run. Markets tend to overreact to bad news, sending assets below fair value. Value strategies exploit this tendency by buying low and selling high.

The most-studied value strategy is price-to-book sorting, popularized by Eugene Fama and Kenneth French. Each year, it buys the stocks with the lowest price-to-book ratios, and either short-sells or avoids those with the highest ratios. It has worked in nearly every equity market studied. In fact, you don’t even have to sort on price-to-book, so long as the measure is plausibly tied to a fundamental measure of value.

I’ve reproduced the results of a classic price-to-book sorting strategy applied to country indexes. The country-level stock market and price/book data come from the French Data Library. The strategy is simple:

  • At the end of each December, sort country equity markets by their price-to-book ratios.
  • Buy in equal weights the six with the lowest ratios (the cheapest markets).
  • Short in equal weights the six with the highest ratios (the most expensive markets).
  • Rebalance monthly.

The strategy produced an excess return of 4.42% annualized for the period 1976 to 2011. With Europe trading at depressed valuation ratios, mean reversion suggests that the region is poised for long-run outperformance.

Curiously, while many investors of the fundamental bent acknowledge mean reversion/value works, they’re hesitant to exploit momentum. However, one can’t exist without the other.

A momentumless market is one in which value can’t work. Naive momentum-based models actually suggest distressed European stocks are in for a rocky ride over the short run.

Using the same country data, I created a long-short momentum strategy that each month goes long the six countries with the highest 12-month trailing returns, equal-weighted, and shorts an equal-weighted basket of the countries with the lowest 12-month trailing returns. This strategy earned 7.63% annualized excess returns. (And, as regular readers know, momentum strategies have worked in nearly every market studied.)

These models suggest different approaches, depending on the time horizon. Far-sighted investors with steely nerves will likely be rewarded with higher returns for piling into Europe. I suggest no more than a 5% overweighting above market weight for the equity sleeve of your portfolio.

Momentum-minded investors should ignore Europe and stick with the US, which has been among the best-performing markets. Rather than pick one model, I prefer to meld them together. I’ll buy Europe when it begins trending upward, either earning a positive 12-month return or breaking above its 250-day simple moving average.

Is This Time Different?
One might be tempted to ignore the suggestions of such simple-minded models in favor of discre­tionary analysis. All the insight you glean from the news about Europe, the motives of the major political players, market flows, and investor sentiment certainly yields a more persuasive picture as to the future of Europe.

You may conclude that it’s different this time. And you might be right. But history shows that most investors are terrible at timing paradigm shifts. Intellectual modesty suggests we hew to simple models and move away from them only when the evidence practically screams that we must. That way, we avoid the hedgehog’s error.

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