When a new government program is announced we can never know what the seen and unseen consequences will be. Similar programs might have failed 100 times before, but this time might be different.
Similarly, in the investment world, we never know what will happen...or why it happens. Still, we have to make our guesses. Sometimes right. Sometimes wrong. And if we're smart, always in doubt.
But some things are more likely than others. If you put your money on housing in 2007 because 'housing never goes down,' you were betting on something that might have been true. Then again, it might not. You were in danger of losing money when the truth was known.
And today, if someone tells you 'housing never goes down,' you are advised to bet against it; because recent experience tells us that that hypothesis definitely not true.
Historically, markets swing back and forth, anchored in some 'normal' range. Stocks, for example, broadly trade between 10 times earnings and 20 times earnings. Occasionally, they are more expensive. Sometimes they are less. When they are more than 20 times earnings, buyers typically have a hypothesis that justifies the higher prices. "This time it is different," the sentence begins, followed by "because..." We can never know that this hypothesis is true. We may know from experience that similar hypotheses have been proven false. But we can't be sure that this one will be disproven too.
But as the price of stocks rise, the potential reward for betting against the extraordinary new hypothesis goes up. We don't know at what point a short position represents good value for money, but it must be there somewhere. As a round number guess, in the stock market, we will say it comes at 20 times earnings. Any time the P/E of the stock market goes over 20, you are probably best advised to get out.
Likewise the same thing happens on the downside. At a certain point, investors think it is the end of the world...or simply the "End of Equities" as Business Week famously put in August 1982, at the very beginning of the biggest bull market in history. Then, they sell stocks too cheaply, based on an unproven hypothesis. Most often, the end of the world doesn't happen and stocks go back up. Again, we can't know at what point it makes sense to bet against the 'end of the world' hypothesis. We'll stick with our round numbers and say 10 times earnings.
Now what do we have? We have a trading system that will knock your socks off!
But let us go back and put this in perspective. In the 1970s a number of academic researchers won fame and fortune - Eugene Fama, Robert Merton, Burton Malkiel -- by showing that markets were 'efficient' and that trading systems of any sort were a waste of time. Rational investors were said to have access to all that was known about companies, profits, the economy, the state of the world - everything. Prices discovered by these investors included all available knowledge. Therefore, prices were correct. An individual may think a particular company underpriced or overpriced, but he could not know as much as all investors put together, so his opinion was just one of many. Aggregated opinions determined the market price; there was no better way to determine what a stock was worth.
Therefore it stood to reason that any investment performance that 'beat the market' was just luck. And that, over time, luck would run out...and returns would regress to the mean.
Warren Buffett famously took on these "Efficient Market Hypothesis" proponents in 1984, in a debate at Columbia University. Representing the EMH crowd was Michael Jensen, a well-known professor from the University of Rochester. Samuel Lee of Morningstar recalls the event:
Buffett responds. He asks you to imagine a national coin-flipping competition with all 225 million Americans. Each morning the participants call out heads or tails. If they're wrong, they drop out. After 20 days 215 coin-flippers will have called 20 coin flips in a row-literally a one in a million phenomenon for each individual flipper, but an expected outcome given the number of participants. Then he asks, what if 40 of those coin-flippers came from one place, say, Omaha? That's no chance. Something's going on there.
Buffett argues "Graham-and-Doddsville" is just that place. He presents nine different funds that have beaten the market averages over long periods, all sharing only two qualities: a value strategy and a personal connection to Buffett. He emphasizes that they weren't cherry-picked with the benefit of hindsight.
In closing, he boldly predicts "those who read their Graham and Dodd will continue to prosper." The crowd goes wild. Later on, at the cocktail reception, everyone's talking about how Buffett crushed Jensen.
Yes, Warren Buffett beat the market - and not by accident. But can you?
More tomorrow...on why investing is a 'loser's game' and how you can pick up the dollar that isn't supposed to be there.
Bill Bonner is the President & Founder of Agora Inc, an international publisher of financial and special interest books and newsletters.