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Watch the big trends and change strategy slowly [ClearOnMoney]
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Commentary

Watch the big trends and change strategy slowly

5 Nov 2009 by Jim Fickett

While there are, of course, sometimes opportunities with very short time windows, these are usually best left to traders. The long-term investor will do well to watch the big trends, which change on a scale of months to years, and likewise change strategy slowly. This helps take emotion, the great enemy of good investing, out of the foreground, and helps prevent mistaking noise for news.

Look back again at the inflation-adjusted price chart for gold. There was a recent period of almost 15 years when gold was priced below its long-term average. That was the time to add steadily to one's position, without worrying about exactly where tops and bottoms might be. (Yes, I do understand that the information available then was different. That does not change the main point.)

In the case of the recent stock market crash, the level of panic did change suddenly and dramatically with the failure of Lehman in Sep 2008. However the informed investor had plenty of time before then to react. First, it had actually been clear for a couple years that there was an untenable situation developing, with unrealistic credit ratings and valuations on complex securities. Second, the failure of the Bear Stearns hedge funds in the summer of 2007 made it clear that banks were no longer going to be able to pretend the valuations on their books were realistic.

as the Bear Stearns funds unwind positions, investors and traders could reassess the value of other debt securities. As a result, investors far beyond the reach of the funds could find their holdings of similar debt worth less than they thought. …

Unlike stocks and Treasury bonds, whose prices are continually quoted and easily obtained, many of these derivative instruments trade infrequently and don't have clear market prices. To come up with market values for these investments – a process known as “marking” their positions to market – investment funds often rely on their own valuation models.

They might also ask the dealers who sell them the bonds to update them on changes in the bonds' underlying value. When there are no sales to base prices on, dealers come up with prices based on their own statistical models and an array of assumptions about what's happening in the market or the assets that back the securities.

“There's some real concern about how realistic dealer quotes are,” said Andrew Lo, a finance professor at the Massachusetts Institute of Technology who is also a principal in AlphaSimplex Group LLC, an asset-management company that also runs a hedge fund. “You're talking about quotes during normal times that are very different from quotes during stress times.”

Wall Street Journal, 20 Jun 2007, pA1, “Two Big Funds At Bear Stearns Face Shutdown”.

As feared, when the Bear Stearns hedge funds had to auction their assets, banks and other hedge funds had to mark their valuations lower, beginning a self-reinforcing process that played a central role in bringing on the crisis. My point is that this key piece of information was available more than a year before the Lehman failure, and those who ignore the daily noise and pay attention to bigger issues were able to make use of it. This was when I got scared and got out of the market. But, really, any time over the next few months would have been fine.

(Five year history of the S&P 500 from Google finance.)

The count of initial unemployment claims comes out weekly, and every week one sees a large number of articles attributing deep meaning to the numbers. In fact, however, there is a great deal of noise in the series, and the trendline follows a curve that only makes major changes on a scale of years. One should really ignore most analysis of the individual numbers and watch a longer term graph. We do a monthly update at US initial unemployment claims. The short story, unchanged since about April, is that claims are in a gentle downtrend, but remain high, at a level implying negative change overall in the number of jobs. In a few months, when that changes, it will be news. In the meantime, ignore the noise.

And what sparked this post: the monthly Employment Situation Report comes out on Friday, and there will be a great deal of excitable commentary trying to extract every last atom of meaning from the data. In reality the underlying facts hardly change from month to month. It will be surprising indeed if the next data point on the graph of cumulative change in non-farm payrolls (US employment) is not in the same neighborhood as the previous few points.