Monthly Archives: May 2014

Looking for an Edge Using Occam’s Razor

Sherlock Holmes and his sidekick Watson go on a camping trip. After sharing a few glasses of chardonnay, they retire for the night.

At about 3 AM, Holmes nudges Watson and says, “Watson, look up into the sky and tell me what you see?”

Watson said, “I see millions of stars.”

Holmes asks, “And, what does that tell you?”

Watson replies, “Astronomically, it tells me there are millions of galaxies and potentially billions of planets. Astrologically, it tells me that Saturn is in Leo. Theologically, it tells me that whatever made all of this is beyond human comprehension. Horologically, it tells me that it’s about 3 AM. Meteorologically, it tells me that we will have a beautiful day tomorrow. What does it tell you, Holmes?”

Holmes retorts, “Watson you idiot, someone stole our tent.” *

This story is a classic example of the principle of Occam’s Razor.  In its simplest form, Occam’s Razor states that when faced with two opposing explanations for the same set of evidence, our minds will naturally prefer the explanation that makes the fewest assumptions.

For decades, pseudo-intellectuals (like me) have been evoking Occam’s Razor whenever discussing (mostly) trivial matters.  In my experience, those who unsheathe this rhetorical construct from their debater’s arms cache, more often than not, do so to show off rather than to defend their point of view.

Today I would like to use Occam’s Razor in two ways: 1) to show that most people seem to prefer the more complicated answer regarding capital markets matters, and 2) to use a simple answer to support my view that we are still in a bull market.

Anyone who follows the daily commentary about the financial markets understands that there are many opinions out there.  Those persons with the most extreme (non-consensus) viewpoints tend to be quoted more frequently than others.  I guess these ideas are considered more newsworthy than less flashy ones.  Recently, I have been bombarded by messages telling me to sell my stocks, buy gold, be prepared for massive inflation, be prepared for even more massive deflation, kiss the American Dream goodbye, feel sorry for my grandkids, expect another global financial crisis worse than the last one, etc.  We hear from Nobel-winning economists that the stock market is overvalued.  We hear that billionaires are selling their stocks.  We hear cautious words from big hedge fund managers.

As outrageous as these viewpoints may seem to me, some people must be seriously considering them.  Each week or so, I receive a forwarded e-mail from a friend, colleague or client stating that the “end is near,” and that the author of the e-mail has the perfect investment product for the apocalypse.  In my view, the vast amount of material like this argues that the general public is looking for a complex answer to the simple question, “Where are stocks going?”  The best simple answer to that question, in my view, is “higher.”  Stock prices, over time, always move upward. In any given year, the markets can experience volatility and price declines, but in the long run, stock investors (who remain invested) always make money. So, the Occam’s Razor answer to the question about the market’s direction could be “higher” (over time).

The current debate about the fragility of the stock market seems to center on 1) the fact that many major indices are at all-time highs and 2) the bull market is old – the “average” bull market lasts about 5 years – right where we are now.  Those calling for a bear market are not content simply citing the above facts; they will buttress their argument with 1) worries about the impact Fed tapering will have on stocks, 2) China’s slowdown, 3) Europe’s on-going problems, 4) wars and rumors of war in divers places, 5) esoteric market technicals (remember the Hindenburg Omen?), etc.

In my view, the bear argument tries to win using a large number of data points much like a lawyer would trying to establish reasonable doubt.  For me, the small amount of my research effort dedicated to macro issues (most of my research effort is spent on individual companies) tries to address the simple question, “Is there a recession likely within in the next 6 months?”  Bear markets usually start in front of a recession. Sure, sometimes a bear market can sneak up on us, but most of the time, they happen because of a looming recession.  If your answer to the simple question posed above is “no” then you (like me) can feel somewhat confident that the bull market is likely to continue.  It’s a good idea to keep a weather eye on the horizon looking for early signs of a recession, but for now “steady as she goes” feels better than doing something dramatically different.  One simple question plus one simple answer equals portfolio peace of mind.  William of Ockham would no doubt be proud…

* Many thanks to Ian Lawton and his website “Soulseeds” (http://www.soulseeds.com/) for sharing this joke with me