Iron Capital Insights

  • Iron Capital Insights
  • February 9, 2015
  • Chuck Osborne

Judgment

This past week all anyone wants to talk about seems to be Pete Carroll’s judgment, or lack thereof. For those who may have missed it, Pete Carroll is the head coach of the Seattle Seahawks who many think would have won the Super Bowl if he had simply called a run instead of a pass on their last offensive play of the game. As it was he said to throw, and throw it they did – right into the arms of the New England Patriots.

We’ve spoken about this before, but it is always amazing to me how coaches are judged by the outcome of their decisions. I played football through high school and have been a fan all my life, and I know that I do not know enough about football to have an informed opinion. From what I have seen most knowledgeable people think that the decision wasn’t the problem; it was just poor execution. However, according to the masses it didn’t work so Carroll is an idiot. Had it worked, he would be a genius and they would be saying how brilliant it was to throw it when everyone expected a run. Many fans seem to believe that whatever happened was the only possible outcome and should have been foreseen.

Some people have the same outlook on financial markets; they believe what happens in the markets must always be the only outcome that could have happened and, perhaps more importantly, the “right” outcome. However, that is not the case at all. Markets are irrational and subject to overreacting. While this has always been the case, there are two modern phenomena that seem to be making it worse.

The first is the increasing influence of computerized trading. Computers can do lots of things well, but judgment really isn’t one of them. My wife and I saw a now-favorite sign on a pub wall in Scotland that read, “Good judgment comes from experience. Experience comes from poor judgment.” In other words, as one ages and learns from mistakes one starts to realize the importance of things like context. For example, it turns out that during the course of the NFL season more than 100 passes from the one yard line had been attempted. Not one of those passes was intercepted until that very last pass. Context changes things a bit, doesn’t it?

Increasingly in the financial world we see this lack of context and I believe it is because of the increased use of computerized trading. For example, take the drop in oil prices. The price of oil has gone from more than $100 per barrel to the $40 range and is now in the low- to mid-$50 range. Last week data came out showing a slight increase in the supply of oil, and the price immediately dropped more than four percent. In the past news like this would have been put into context. Yes, oil supplies are higher, but only slightly, and we have had a more than 50 percent drop in the price already. But, computers don’t do that. They do “supplies up equals sell” orders.

This phenomenon is causing greater price swings than in the past. Human traders may still have a short-term mentality, but they would look at that situation and say that the bad news is already baked into the price. In fact two days later that is what has happened as oil prices have rebounded and then some, but on that day, one data point taken out of context created market volatility.

The second phenomenon is the trading of Exchange Traded Funds (ETF) as a replacement for individual stocks. Many traders are trading entire industry groups through the use of ETFs instead of just the stock of a single company. When a company reports poor earnings, the computer says “poor earnings equals sell,” and instead of selling the stock of that company the computer sells the ETF of the company’s industry.

The problem is that there are at least two different reasons a company may have poor earnings. First, their entire industry is down, in which case selling the ETF may be logical. Second, and more often, they are getting beaten up by one of their competitors. In that case selling the ETF does not make any sense because what you have is not a bad industry but a winning company and a losing company. The winner is also in that ETF, so why would one sell them? Poor judgment.

Both of these phenomena are causing increased volatility at the individual stock level. Both are very annoying to long-term investors, but they are also creating opportunities. Traders see the buying and selling of financial instruments the same way they see a football game. They believe the game ends and you either won or lost.

That is not how investors see the world. The game never ends, the outcome is never certain, and one knows only where they are along the journey at that moment. The traders don’t really care how illogical their actions are as long as they are able to get out fast enough to make a small profit…which means these phenomena are not going away. As investors we have a choice: we can cry about it, or take advantage of it.

Fortunately for investors our entire season never rests on one throw; we get to diversify. No official ever blows the whistle; we get to keep playing and exercise patience. If one makes calls that work more than one hundred times before not working once, then over time he will do very well. Good judgment – prudent decision-making – does not guarantee instant success, but it does produce lasting success.

Warm Regards,

Chuck Osborne, CFA
Managing Director