Michael Jordan, Market Efficiency, and Moneyball

NBA and a Random Walk

Psychologists wrote a detailed study of every shot the Philadelphia 76ers made over one and a half seasons of basketball. The psychologists found no positive correlation between the previous shots and the outcomes of the shots afterwards. Economists and believers in the ‘random walk hypothesis’ apply this to the stock market. The actual lack of correlation of past and present can be easily seen. If a stock goes up one day, no stock market participant can accurately predict that it will rise again the next. Just as a basketball player with the “hot hand” can miss the next shot, the stock that seems to be on the rise can fall at any time, making it completely random.

How is that for a reassuring start! Fortunately, the world is not completely black and white (remember 50 shades of grey?). Ok, maybe not a good example, but you get what I mean. Plus, I suspect Michael Jordan would have something to say about the correlation of the shots he has made.

Other really smart people have done some mathematical studies that present evidence that the random walk hypothesis is wrong and that there are, in fact, some trends that are somewhat predictable or at lease persistent.

Ok, back to Jordan for a second. In his 13 seasons with the Bulls, he averaged 83.8% from the free throw line. Now, he took some time off (about 3 seasons to be exact) and came back to play with the Washington Wizards for 2 seasons. From the line in those two seasons, he tossed in 80.5% of the shots he attempted. Basically, he was a good shooter, but he could miss.

If we simplified this approach to being able to find a Jordan in the market place or a strategy in financial markets, we could invest with this knowledge and have a decent experience over time with the recognition that sometimes we would miss some shots. Sounds easy?

Efficient Market Hypothesis

In financial economics, the efficient-market hypothesis (EMH) states that it is impossible to "beat the market" because stock market efficiency causes existing share prices to always incorporate and reflect all relevant information. Today, with the development and efficiency of information delivery, this hypothesis perhaps has greater meaning than 20 years ago before the flip phone. With the aggregation of all information in one place, surely no one person would have an advantage over another looking at the same information. Right!?

However, perception or interpretation of information is often different from two different people. To make the simple more complex, have a look at this interesting illusion of how one interprets information and optically what it challenges you to actually see:

https://www.youtube.com/watch?v=QbKw0_v2clo

Two things happen in this video: the nose on the back of the mask appears to protrude outwards, and the rotation of the mask appears to change direction. However, we know the facts that this just cannot be true, but our mind uses top down perceptions versus bottom up processing. This is where it gets a bit academic, but suffice it to say we all perceive things differently.

According to the EMH, stocks always trade at their fair value on stock exchanges, making it impossible for investors to either purchase undervalued stocks or sell stocks for inflated prices. As such, it should be impossible to outperform the overall market through expert stock selection or market timing, and that the only way an investor can possibly obtain higher returns is by purchasing riskier investments.

But wait: remember Jordan hitting 80% of his shots from the free throw line? I suspect that when the Wizards brought him back they were pretty certain that he could still put the ball in the net. Yes, of course there is some persistence in good companies and good sectors, just like great basketball players. Just like there is persistence in bad companies and bad sectors. Times definitely change, and better shooters will come along. This is just the nature of basketball. It is also the nature of life, economies, and capital markets.

Our challenge is to digest these changes, and find those that are persistent and allocate capital. When that change happens we must make the decision to change.

This is likely where EMH gets a bit complex. A coach knows when his player needs a rest and is just not shooting his best. Phil Jackson coached Jordan for years and knew when to sit him down, and also knew when to have him on the floor. He made those changes mid-game on the fly as a good coach should. The capital markets are a bit tougher because you, in theory, have an endless arrangement of different players that you can put on the court at any one time. There are literally countless ways to structure a portfolio. This is where some great teams have moved the decision making on adding new players to their roster to algorithms – they call this money ball. Jackson knew that when Jordan was at the free throw line, he would hit 80% of his shots. He also knew that when Dennis Rodman was on the floor, he would only hit 54% of his free throws, but there was a time and a place for Rodman, and Jackson knew this better than anyone else.

The money ball approach has found its way into financial markets in wide and different ways. One of the more simple pieces of recent research has been the three factor approach. This approach suggests owning only any of, or none of, the US Long bond index, Gold or the S&P 500. The factors in determining the ownership of any of these assets are the presence of them technically having their short term moving average (moving average 1) above or below their longer term moving average (moving average 2). Looking at the S&P 500 for example on a technical basis, the theory would argue that you would own this index because the short term moving average price is above the longer term moving average. You would have purchased the index back in March of 2012 and held the position up to, and including, the time of this writing (June /July 2015).

If we were to look at the contrary asset in this space (gold), the strategy suggests that one would have been a seller of the asset class in March of 2013, and would have remained out of the asset class until the point on the graph below.

The two examples above suggest and demonstrate that having a good player on the court like a Jordan or an asset like the S&P 500 over the past number of years was good as an investment. To the contrary, it also provided data on an asset class that was not as attractive (gold) and stayed away from that asset class for a number of quarters. Neither of the asset classes above will remain on their current direction forever, but they have been persistent in their trend and helped both protect and build capital.

Do strategies like this (Money Ball) work in all weather?

Yes and no! Yes, over time, we can say with certainty that this approach works well, but you need to remain disciplined. Consider for a moment the passive investor that buys an index and just decides to hold it through thick or thin. We can use the S&P 500 over selected time periods to demonstrate how buy and hold does not work. Consider the period from 2000 to 2007. Had you just purchased the S&P 500 index you would have had a flat experience over that 7 year period.

Now, if we add a simple strategy of using our moving averages, we would have been out of the S&P 500 in December of 2000 and returned to the index in July of 2003 until February of 2008 (out again). If we took a very simplified approach to total return during that time period, consider the difference:

1) Buy and Hold the S&P 500 (no dividends reinvested, simple index price return December 2000 to February 2008):

3.06%

2) Using an Active Trend Following approach to the S&P 500 (no return on cash, no dividends reinvested, simple index price return December 2000 to February 2008):

38.10%

This is meaningful, and we need to pay attention to these difference.

So where do we go from here? We know some truths about the markets, and we also know a fair amount about behavior and efficient market hypothesis. Going forward, we will continue to explore and filter these concepts to find better ways to protect and grow capital.

Our experience continues to tell us that it makes sense to continue to look for better companies and better asset classes in difficult environments.

Jordan after all did eventually retire and then this James guy came along…….

 

Sources:

VIP Wealth Solutions

Bloomberg

Basketball Reference.com

Wikipedia

Investopedia

SimplePsychology.org