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Greg tackles the myths of investing over time from seasonality, correlation, and statistical lies. No matter what Wall Street theory you might have believed, Greg drills holes in it. (Presentation Deck)

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You are on page 1of 53

In Modern Finance

And Technical Analysis

1

Gregory L. Morris

• Aerospace Engineer – Univ. of Texas, 1971

• Top Gun Fighter Pilot – US Navy, 1971 - 1978

• Airline Captain – Delta Air Lines, 1978 - 2004

• Software Developer – 1979 – 1995

• N-Squared Computing

• Windows on Wall Street

• G. Morris Corporation

• Authored “Candlestick Charting Explained (1992, 1995, 2006), Complete

Guide to Market Breadth Indicators (2005), “Candlestick Charting Explained

Workbook (2012),and Investing with the Trend (2013)”

• Founder and CEO of MurphyMorris.com (1995 - 2002)

• Started MurphyMorris Money Management in 1999

• Sold MurphyMorris.com in 2002 to Stockcharts.com

• MurphyMorris Money Management acquired by PMFM in 2004

• PMFM became Stadion Money Management in 2009

• Over $5.5 Billion AUM

• Six mutual funds, separate accounts, and 401k plans

• Currently semi-retired

– Writes blog on StockCharts.com called Dancing with the Trend

– Consultant for Stadion Money Management and Chairman - Board of Trustees

– Struggling to keep golf handicap below 18

My Favorite Books

3

Believable Misinformation

• George Washington cut down a cherry tree.

• Some believe water runs out of a bath tub

faster as it gets toward the end.

• Dogs sweat through their tongues.

• How many think that Dec. 21st in the

northern hemisphere is the shortest day of

the year?

• Bath water drains counter-clockwise in the

northern hemisphere.

4

Question

• If you believed something that you

learned when you were young from

your parents or teachers, then…

– How many things about investing and

finance do you also believe but have never

questioned?

• That is the purpose of this

presentation.

– Market Fiction

– Market Flaws

5

Believable Misinformation

• Buy and Hold is the only way to be successful in the stock

market.

• Dollar cost averaging is a good technique.

• Diversification will protect you from bear markets.

• Compounding is the Eighth wonder of the world.

• You must remain invested at all times or you will miss the

10 best days each year.

• Average returns are never better than compounded

returns.

• Probability and risk are the same thing.

• Equity asset allocation will protect you from bear markets.

• Economists are good at predicting the market.

• Chasing performance is a common technique.

6

This is what Modern Finance

Uses

8

Dow Industrials Drawdown

Bear Markets Can be

Expected

**A 41.79% declines requires a 71.78% gain to break even!
**

Dow Jones Industrial Average

Feb. 17, 1885 – Dec. 31, 2013

**100% - 96.27% = 3.73%
**

Historical Dow Jones

Industrials

Let’s play a game!

12

Equivalent Returns

13

Missing the 10 Best / Worst Days since

1979

14

Missing 10 Best / Worst

since 1926

15

16

17

Compounding is the

8th Wonder of the World

Investment Option Investment Option

A B

Year 1 +10% +36%

Year 2 +6% +8%

Year 3 +8% -20%

Average +8% +8%

Growth of $100 $126. $117.

Compounded +8% +5.4%

Return

18

What is Wrong with

Modern Portfolio Theory

• The markets are efficient.

• Investors are rational.

• Returns are random.

• Returns are normally distributed.

• Gaussian (bell-curve) statistics is appropriate for

use in finance/investing.

• Alpha and Beta are independent of correlation.

• Volatility is risk.

• Is a 60% equity/40% fixed income appropriate?

• Comparing forward (guesses) PE with long term

trailing (reported) PE.

19

What MPT Forgot or Ignored

• Do people trade / invest using different

time horizons?

• Are there different views of risk among

traders / investors?

• Are there different views on where a stock’s

price will be in one week, one month, one

year, etc.?

• CAPM assumes investors AGREE on return,

risk, and correlations of all assets and

invest accordingly.

20

Gaussian Statistics (Bell

Curve)

21

Reality vs. Theory

22

Probabilities of an Event

Sigm Population in Range Expected Interpretation

a Frequency

Outside Range

(1 in X)

0.5 0.383 1.621 Three times a

week

1 0.683 3.151 Twice a week

1.5 0.866 7.484 Weekly

2 0.954 21.978 Every three weeks

2.5 0.988 80.520 Quarterly

3 0.997 370.398 Yearly

4 0.999 (plus one 9) 15787.193 Every 43 years

5 0.999 (plus three 9s) 1.744 x 106 Every 4,776 years

6 0.999 (plus five 9s) 5.068 x 108 Every 1.39 million

years

7 0.999 (plus eight 9s) 3.907 x 1011 Every 1.07 x 109

years

8 0.999 (plus fourteen 9s) 8.037 x 1014 Every 2.20 x 1012

years

9 0.999 (plus eighteen 9s) 4.430 x 1018 Every 1.21 x 1016

years

10 0.999 (plus twenty-eight 9s) 6.562 x 1022 Every 1.82 x 1020

years 23

12 0.999 (plus thirty-two 9s) 2.815 x 1032 Every 7.71 x 10 29

Shortcomings of Sigma

• October 19, 1987 – a 22 Sigma Event

• Twenty-two sigma as shown in previous table, based

upon Gaussian statistics, should only occur once in every

9.5 x 10103 years.

• The speed of light is approximately 186,282.21087 miles

per second, so the speed of light in miles per hours is

(186,282 x 60 x 60) = 670,615,200 miles per hour.

• Further expansion shows that the speed of light per day

is (670,615,200 x 24) = 16,094,764,800 miles per day

and so the speed of light per year is (16,094,764,800 x

365.25) = 5,878,612,843,200 miles per year.

• In scientific notation this is expressed as 5.878 x 10 12. Or

about the expected frequency of 8 Sigma.

• October 19, 1987 – a 22 Sigma Event

24

Does Academic Sigma Hold

Up?

**To determine average To measure the actual
**

daily return and sigma; returns outside +/- 3 sigma

this determines the range

for 3 sigma about the mean.

25

5 Yr. Look-back – 5 Yr. Look Forward

**Period Start End Date Number Avera 3 Sigma # #
**

Date of ge Range Days Days

Days/Ye Return + -

ars Sigm Sigma

a

Look- 10/27/19 10/20/199 1260 / 5 0.07% -2.06% to

back 92 7 2.21%

Look- 10/20/19 10/24/200 1260 / 5 49 69

forward 97 2

26

Risk vs. Uncertainty

• Is volatility risk? (here we go again)

• In the sterile laboratory of modern finance, risk is defined by

volatility as measured by standard deviation; however...

• It assumes the range of outcomes is a normal distribution (bell

curve)

• Rarely do the markets yield to normal.

**• When an investor opens his/her brokerage statement
**

• It shows the following portfolio data for the last year:

• Standard Deviation = .65

• Loss for the Year = -35%

• Which one do you think will catch their attention? I seriously

doubt any investor is going to call their advisor and complain

about a standard deviation of .65. However, the -35% loss will

get their attention. Even investors who have no knowledge of

finance or investments know what risk is – it is the loss of capital.

27

Risk vs. Uncertainty

• Risk and Uncertainty are NOT the same thing.

– Risk can be measured.

– Uncertainty cannot be measured.

**• A jar contains 5 red balls and 5 blue balls. In the old
**

days we called it an urn instead of a jar.

– Blindly pick out a ball.

– What are the odds of picking a red ball? There are 5 red balls

and the total number of balls is 10. Therefore the odds of

picking a red ball are 5 / 10 = .5 or 50%.

– That is Risk! It can be calculated.

• Suppose you were not told the number of red or blue

balls in the jar.

– What are the odds of picking a red ball?

– That is Uncertainty!

28

Risk and Uncertainty

• Risk is not volatility

• It is Drawdown (loss of capital)

• However, in the short term, volatility

is a reasonable proxy for risk

• But over the longer term, drawdown

is a much better measure of risk.

• Volatility does contribute to risk but it

also contributes to market gains.

29

The Heart of MPT

Diversifiable 60% - 70% is Non-Diversifiable Risk

**Non- Systematic or Market Risk
**

Systematic Technical Analysis

**Capital Asset Pricing Model
**

Modern Portfolio Theory

Risk is at the

Efficient Market Hypothesis

heart of many of

Random Walk

these theories!

Option Pricing Theory

30

Withdrawals and Bears!

6% Withdrawal

3% Inflation

adjusted quarterly)

31

Linear Analysis Nonsense

• The “world of finance” is locked into

it.

• Be very careful with it or the results

are bogus.

• Basically it is taking data and

creating a straight line to represent

it.

• Whiteboard time… y = mx + b

32

Academic Alpha and Beta

33

FEAR of negative numbers

34

35

36

60 / 40 Myth (1960-2010)

37

60 / 40 by Decades

Did you want 40% in bonds here?

Did you want 60% in stocks here?

38

Discounted Cash Flow Model

• Discount Rate

– Cost of Equity, in valuing equity

– Cost of Capital, in valuing the firm

• Cash Flows

– Cash Flows to Equity

– Cash Flows to Firm

• Growth (to get future cash flows)

– Growth in Equity Earnings

– Growth in Firm Earnings (Operating Income)

Hubble Telescope

39

85 Year Annual Returns

What is wrong

with this?

** Small Large LT LT Govt. It T-Bills Inflatio
**

Caps Caps Corp. Bonds Govt. n

Bonds Bonds

Cumulat 18,366.9 3,531.23 173.08 122.13 93.00 19.58 11.81

ive 3

Annualiz 11.95% 9.85% 6.11% 5.69% 5.36 3.54% 2.97%

ed 40

Mean 16.5 11.8 6.4 6.1 5.5 3.6 3.1

Average is not very Average

**Six foot Texan
**

41

Illusion of Forecasting

• No better than guessing

• No long-term accuracy

• Cannot predict turning points

• No leading forecasters

• No forecaster was better with specific statistics

• No one ideology was better

• Consensus forecasts do not improve accuracy

• Psychological bias distorts forecasters

• Increased sophistication does not improve accuracy

• No improvement over the years.

• Kenneth Arrow Story

**William Sherden, The Fortune
**

Sellers 42

Why do Investors like Predictions?

• If the Investor loses money, they can blame the

forecast.

• Confidence in a forecast rises with the amount of

information that goes into it.

• But the accuracy of the forecast stays the same.

• It’s that you can be a successful investor without

being a perpetual forecaster.

• Not only that, I can tell you from personal

experience that one of the most liberating

experiences you can have is to be asked to go

over your firm’s economic outlook and say, ‘We

don’t have one.’

43

Sell in May and Go Away!

• Just statistics – you cannot make an

investment decision from it

• When in May do you sell?

• When in November do you buy?

• Let’s say the statistics show it works 75% of

the time.

• Not bad, right?

• If you started using this strategy, and the first

3-4 years contributed to the 25% of time it did

not work, then…

• How long would you stick with this?

44

Analog Charts

What is the Correlation?

A. Closer to 1

B. Closer to 0

C. Closer to -1

D. Can’t tell

Correlation =

-1.0

How?

Correlation of Daily Returns

• The process was:

– Day 1: Series A: +1.0%, Series B -0.5%

– Day 2: Series A: -0.5%, Series B + 1.0%

• Over any period of multiple days,

both series advance, but they

do so in perfect

inverse daily

correlation.

Correlation?

+1.0

**orrelation is ever and always a mathematical proces
**

Spurious Correlation

49

This is how Technical Analysis Works

1 + 1 = 2

50

Greg’s Rules

• 1. Turn off the TV and stop surfing the Internet for advice (stop the

noise).

• 2. Develop a simple process, one that you can explain to anyone

(mine is trend following).

• 3. Create a security selection process based upon momentum.

• 4. Devise a simple set of prudent and reasonable rules and

guidelines.

• 5. Follow your process with discipline; without it, you will fail.

• 6. If you do not have the discipline to do this, seek professional help

from someone who does.

• 7. Do not be upset with yourself if you do not have the discipline at

times; be proud of yourself for recognizing it.

• 8. Do not confuse luck with skill.

• 9. Listen and learn from the market – it is always right.

• 10. Read this list often.

Pot At The End of The

Rainbow?

The End

53

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