In the short run, market is a voting machine; in the long run, it’s a weighing machine. – Benjamin Graham
Price is a measure of Sentiment
Early last year, when it became clear that the China Virus had spread all over the world and was getting millions sick, overwhelming healthcare systems everywhere, the markets tanked. In USD terms, Indian stocks were down more than 40% and the S&P was down more than 30%.
Then, a miracle cure was discovered and the markets quickly recovered.
Just kidding!
Governments and Central Banks everywhere did whatever they could to lift sentiment. And markets quickly followed.
Sentiment remains one of the least understood but the most important factor in investing. All prices are eventually tied to how optimistic or pessimistic investors are feeling about the future.
While Graham’s weighing machine might arrive in time for tenured investments, like bonds, that have a fixed maturity date, perpetual securities like stocks are always at the mercy of the voting machine, i.e., sentiment.
The Market sets the Price
For stocks, Price = multiple x earnings
For prices to go up, you don’t need earnings to go up. It is enough if multiples do.
There are two pieces that drive returns… multiple expansion / contraction and the earnings themselves. It’s hard to predict the former (they’ve gone opposite their expectation of normalization), but they completely whiffed on the fundamentals. US companies have crushed.
Russell 1000 Growth Price to Book Grew from 5.2 to 12.4 in 5 Years…Russell 1000 Value 1.5 to 1.6 in Same Time Frame … forward P/E has doubled for growth and flat for value over past 5 years. h/t TOPLEY'S TOP 10 via @MarketWatchpic.twitter.com/0zj1DlkIjz
The market doesn’t care why you are transacting. Only that you are. It doesn’t matter what your investment horizon is or the type of investor you are, all transactions take place in the market at a price set by it.
As an investor, you can be right about the company (direction of earnings) but wrong about the sentiment (direction of multiple) and can end up with a stock that goes nowhere in price for years and exit with no rewards for your effort.
No such thing as Buy-and-Hold Forever
It is the end of a “long-term” for a subset of investors everyday.
Investors usually save with a specific goal in mind. These goals tend to be time bound: retirement, kid’s education, etc. While their horizons can be “long” at the outset, it gradually shortens as the D-day arrives. Equities (and other high-risk securities) are constantly being sold and rotated into bonds (and other low-risk securities) set by a glide-path.
As much as professionals like to fantasize about long-term investing, the investors in their funds have bounded horizons. This is especially true for open-end funds.
Sentiment + Finite Holding Periods = Volatility
Finite holding periods create the need to transact. This makes it impossible to ignore sentiment. The two combine to create volatility.
It is easy to blame investor greed and fear for bad portfolio outcomes. We have all seen this sketch make the rounds:
However, even if an investor overcomes the call of greed and fear, it is impossible to ignore time. This makes sentiment the prime determinant of investment outcomes.
If you think investors having longer time-horizons can ignore volatility. Think again. As the chart above illustrates, volatility is an equal opportunity hater.
Embrace and Extinguish
Volatility clusters. You have reasonably long periods of calm, then suddenly a lot of things “go wrong.” Markets gyrate and you feel that all hell has broken lose.
This leads investors to assume that periods of calm are normal and volatility is abnormal. But in markets, the reverse is true. Sudden shocks, volatility and jolts to sentiment are the norm. Calm periods are the anomaly.
Sentiments wax-and-wane. Multiples expand and contract. Markets melt-up and melt-down for no good reason.
The only time-tested way of reducing volatility is asset allocation. Invest in a basket of different assets (make sure that at least a few of them a not financialized) and accept the market for what it is.
Embrace volatility and extinguish it.
Looking for a sensible way to invest? Here’s how to get started.
In Where Good Ideas Come From: The Natural History of Innovation (Amazon,) author Steven Johnson lays out a big-picture of how ideas are formed and how to setup an environment that fosters innovation.
Readers in a hurry can stick to the last chapter of the book. That’s pretty much where the meat of the book is.
Take-aways:
It is important to just get started solving a problem. And do it publicly if possible. You may not solve the problem you set out initially but along the way, you will find a solution to something else entirely.
Error often creates a path that leads you out of your comfortable assumptions. Being right keeps you in place. Being wrong forces you to explore. Some of the most important innovations in history have taken a long, messy torturous path.
Markets allow good ideas to erupt anywhere in the system. The decentralized pricing mechanism of the marketplace allows an entrepreneur to gauge the relative value of his or her innovation. If you come up with an interesting new contraption, you don’t need to persuade a government commission of its value. You just need to get someone to buy it.
In 1996, a federal mint employee was eating bananas near where US dollar bills were being printed, and a Del Monte sticker on one of the bananas fell into the printing press and got under a transparent layer of a $20 bill. The Del Monte note was created. This particular $20 note is a collectible in some circles and has been auctioned many times before, and most recently for around $400,000. That the serial number of the note is printed over the Del Monte sticker makes this even cooler, and kind of unforgeable, and a fungible token became a non-fungible token.
What?
What does it mean for something to be “fungible” anyway? As an example, dollars (or any money for that matter) are fungible. That is, a dollar is a dollar is a dollar. It doesn’t matter if it’s a note with serial number XYZ or ABC or a ledger entry in some bank’s database. If I give you a $10 bill to transfer an equivalent value, the actual printed bill is irrelevant. This was made much easier when we went from cash (physical transfer of value) to digital transfer of value, and we now transfer an abstract notion of $10 without having to bother with a physical vehicle to carry that value. Now that we have digital money like your bank deposits or Bitcoin – what is the equivalent of the Del Monte note? We will get to that question in a bit.
In the physical world, there are two primary requirements for an object to become a collectible.
It should be one-off, or a limited edition.
It should have some intrinsic appeal because of aesthetic reasons (a Picasso, a Ferrari 250 GTO) or quirky reasons (the Del Monte note).
The appeal of a collectible is driven by popular culture. That’s beyond the scope of this article. The limited edition nature is what I am interested in.
Limited Editions and Artificial Supply Caps
Most paintings appreciate in value after the painter has died. This makes that artist’s work provably limited edition. In rarer cases, the technology used to create the collectible in question is provably obsolete, or some raw materials have become extinct. Many times, if the creator is still active, they could implicitly make a promise that the collectible is limited edition. For example, the car company McLaren has implicitly promised us that they won’t make more of their iconic F1 supercar from the 1990’s. Or Ferrari with their 250 GTO from the 1960’s. Note that there is no technical reason that prevents them from making more of these cars. It’s just that if they break their word, the collectible nature of these cars will vanish.
On the other hand, Seiko and Casio G-Shock, the Japanese watchmakers, make many limited edition collections of watches every year. In the watch collectors’ community, it’s almost a joke when a new “limited edition” Seiko comes out. Sure, there will only be 50 of these specific watches with some specific quirk, but tomorrow, there will be another limited edition collection with some other quirk. Eventually, even among watch collectors it’s hard to know which of these is a true collectible, and which is not. But they are all limited edition, according to Seiko.
What about collectibles in the digital world, where anything can be copy-pasted? Making a limited edition of anything is quite hard. For the most part, digital money is the only thing that cannot be copy-pasted. Government controlled digital money does this by having a centralized database with a trusted party (commercial or central banks) and this trusted party is – er – trusted to not copy-paste. Bitcoin and related cryptocurrencies prevent copy-paste using cryptography, distributed computing, and game theory.
If you can make a unit of a digital money unique, by affixing a banana sticker on a it digitally, you get yourself a digital collectible, or a Non Fungible Token (or NFT).
Can we “affix a banana sticker” on a unit of digital money in your savings bank account?1 Bank account balances are not represented as cash-like notes with serial numbers. Every account has just a numerical balance, and that makes it quite hard to take a part of that balance, and affix a banana sticker on it. So, that’s out. What about the other money that we know about: Bitcoin? Bitcoin is cash-like, in the sense that each digital unit of Bitcoin (technically called a UTXO, or Unspent Transaction Output) has a unique serial number associated with it. But how do we affix a banana sticker on it? For better or worse, Bitcoin is a bit too focused on being a secure implementation of money, and makes affixing this banana sticker much harder, like that Del Monte note was a one-off with the US dollar, but most US dollar bills are unmarked and fungible. Bitcoin is out.
What if we had Bitcoin-like platforms where affixing banana stickers on non-copy-paste-able digital tokens is easy. These are NFT platforms built on Ethereum.
A bit of history here: Ethereum, being a more ambitious platform than Bitcoin, wanted to allow general purpose computation on a decentralized system with no central operator (the opposite of say, Google Cloud or Amazon Web Services). General purpose computation is all fine and dandy, but most users wanted coins equivalent to Bitcoin, but with more fine-grained control on how the actual units were minted and transferred. Note that Bitcoin itself has these minting and transfer rules, but they are all set in stone. Ethereum’s underlying currency: Ether, also has such rules, and for the most part, they are also hard to change. But if a single user wanted to create their own such coin platform, with their own minting and transfer rules, they could create such a platform on Ethereum. This platform standard was called ERC-20, and all the ICO’s you heard about from 2017-2018 were ERC-20 coin platforms with specific mint and transfer rules created by specific teams. To give another analogy, every ERC-20 token-platform is like a bank. Users of a specific ERC-20 token-platform have their own account in this bank with fungible ERC-20 tokens in these accounts, and can transfer these tokens from their account to someone else’s account. This entire ERC-20 bank, along with other such banks, are all built on Ethereum. There are 1000’s of popular ERC-20 token-platforms on Ethereum, with each of them having many users.
One such platform is Cryptopunks, which is an ERC-20 token platform created by a company with 2 engineers. Cryptopunks added one new feature to each of its erstwhile fungible tokens. Each token is associated with a unique 24×24 pixel art image representing various human like faces, which added – er – personality, to each token. It turned out that these tokens were now not fungible at all – some of these tokens have cooler personalities and are valued higher. Thus was born the ERC-721 standard, which allowed token-platforms to add a unique personality to each token that the platform mints. The ERC-721 standard is also popularly known as the NFT standard. Any token-platform that conforms to this standard allows creation/transfer/showcase of tokens with personalities – and sometimes, the personality is as random as a random string of 32 characters. The digital fingerprint of an image file can be 32 characters, and if you add such a fingerprint to a token – this token now has art associated with it. You could add digital fingerprints of music files to a token. Cryptokitties is another famous NFT platform on Ethereum – where each token represents a kitten, with kitten like features – all digital, of course. Note here that the token is associated with the token platform, which is in turn associated with the meta-platform on which the token-platform is built. Could the same 32 character fingerprint of some art be associated with a token from another NFT-platform? Yes, it can be.
Point:
NFTs liberate art. Traditional art is confined to time and space. You have to be in the right city, go to a museum, be invited to someone's home, etc. Anyone, anywhere with an Internet connection can view NFTs and take them in. This is a huge breakthrough.
That doesn't answer my question. If I look at a NFT of a picture how is that a different experience than just looking at the picture online? If there is no difference then how is this revolutionary for viewing art?
After all that background, the main question is – are NFT’s valuable? From the earlier analogy, we could ask ourselves – are watches valuable? There are more watches coming out every year – and Seiko makes many limited edition collections every year – is a particular Seiko watch from a particular limited edition collection worth $69 million? You have surely heard of the Paul Newman Daytona Rolex. As we said earlier, it’s hard to understand the popular culture that makes something a collectible. But, what’s definitely understandable is – what makes a digital artifact a limited edition. The NFT standard says nothing about NFT’s being limited edition. It just says that there should be a way to create NFT’s, transfer ownership, and show their uniqueness. So, we have to trust the NFT platform that it will somehow enforce the limited edition nature of these tokens. In Ethereum, the computer code (also called a smart contract) that controls any deployed NFT-platform cannot be changed after it’s been deployed. This gives us some notion of trust: we can inspect the deployed code, and check for ourselves tokens minted by this smart contract are truly limited edition. Does that give us true limited edition now? Not quite – there are two major caveats.
Deployed smart contracts can be modified in the future, if there are backdoors or hooks, in the code. Proving their non-existence is quite hard. Foundation App, a popular NFT-platform, is just one public backdoor. The contract can be changed unilaterally by that organization in the future.
An organization which deploys the V1 version of the NFT-platform could deploy a V2 version tomorrow, and a V3 version next year. If the organization puts enough marketing around these new versions of the same platform, users move. Case in question – Uniswap, the popular DeFi exchange contract is now in its V3 version.
Short version:
The NFT token you bought either points to a URL on the internet, or an IPFS hash. In most circumstances it references an IPFS gateway on the internet run by the startup you bought the NFT from.
Oh, and that URL is not the media. That URL is a JSON metadata file
In contrast, Bitcoin was deployed just once, and cannot be changed. And the code is open and has been pored over by normal users, bounty hunters, cryptographers, butt-hurt software engineers, and other experts over the last 11 years and it’s almost certain that there is no backdoor. A backdoor could be built in the future, but it will be very hard, and very visible. An NFT, on the other hand is a single token created by one among many NFT-platforms, on top of one among many meta-platforms like Ethereum. To put that in context, there are around 10,000 NFT-platforms on just Ethereum right now. If we leave Ethereum, we get other blockchain platforms, which are ostensibly decentralized across the world – and NFT-platforms are being built on them. NBA TopShot NFT-platform is on the Flow blockchain meta-platform. I have no idea how Flow works.
To give a concrete example, let’s take the NFT that captured the popular media’s limited imagination. Beeple’s $69 million “EVERYDAYS: THE FIRST 5000 DAYS”. The painting itself is 300+ MB, and like most NFT’s is not actually stored on the blockchain, but somewhere else on the internet. It’s not that easy to find, but I will save you the trouble by pointing to a link the works (for now).
Here’s how it was done:
A SHA256 hash of the actual image file – its digital fingerprint – was computed.
The fingerprint was then affixed to a token minted by a smart contract that lives on the Ethereum blockchain. This smart contract is actually called “MakersTokenV2” (no, I am not making this up).
The token was then transferred to the buyer’s Ethereum wallet. The buyer apparently paid the equivalent money in Ether to Beeple through Christie’s, the auction house.
Ironically, this transaction itself cannot be traced on the Ethereum blockchain. We really don’t know for sure if the money was truly transferred or not. Assuming the transaction happened, the buyer now owns the right to transfer the token on the MakersTokenV2 smart contract on Ethereum to someone else.
A grand total of 10 people might have inspected the MakersTokenV2 code. We know not what we know not.
There is this other idea that poor artists, ripped-off musicians, multi-billion dollar sports-organizations like the NBA could associate their content with an NFT platform and get better remunerated for it. Each piece of content goes on a specific token from a specific NFT-platform, and committed fans will buy them. What I fail to see is how an NFT-platform is different than a private art-gallery or a record label, or a pay-per-view sports channel. They can all channel money to the artist, and they can enforce copy-paste protection through law. If a piece of art is fingerprinted and attached to another token on a competing NFT-platform, and this token is then sold – what happens? The artist or the NFT-platform representing the artist will sue the other platform or buyer. Or some such.
So, are NFT’s a fad? Yes.
Is every Bitcoin an NFT? Technically, yes. But every Bitcoin is worth the same value as every other Bitcoin.
Is every USD bill with a unique serial number an NFT? Technically, also yes. But every dollar bill is worth the same value as every other dollar bill. The Del Monte note though, is the kind of NFT that is in vogue now for being an NFT. That’s the fad part.
Looking for a sensible way to invest? Here’s how to get started.
Business Adventures (Amazon,) is a collection of stories written by longtime New Yorker contributor John Brooks that capture the zeitgeist of the late 60’s.
It is dated and most of the stories are quite boring. And the few interesting ones, like the Piggly Wiggly short squeeze or the Ford Edsel disaster, have been discussed ad infinitum.
Quotable:
Most nineteenth-century American fortunes were enlarged by, if they were not actually founded on, the practice of insider trading. Not until 1910 did anyone publicly question the morality of corporate officers, directors, and employees trading in the shares of their own companies, not until the nineteen twenties did it come to be widely thought of as outrageous that such persons should be permitted to play the market game with what amounts to a stacked deck, and not until 1934 did Congress pass legislation intended to restore equity.
The biggest advantage that retail investors have is that they don’t have to worry about managing a huge portfolio with different types of investors with differing time-horizons and expectations. And of course, there’s the straightjacket of mandates that bind professional investors.
The problem with bucketing yourself as a “value investor,” “contrarian,” “growth,” or “momentum guy” is that you lose the biggest advantage that you have: flexibility and the ability to adapt to the market. Mandates, or lack thereof
Broadly, at a meta-level, investment strategies can either be Ferraris or busses but not both. They are built with different uses in mind. A Ferrari is not going to be able to seat 40 people or tug a 40 ton rig. And you don’t build a bus to go 0 to 60 mph in 3 seconds.
As a retail investor, your life becomes a lot simpler if you decide upfront if you want to drive a Ferrari or take the bus. But once you get on one, be at peace with your decision. Most investors would be better off taking the bus: DCA/SIP into a mutual fund, don’t chase performance, focus on asset allocation and increase your income and savings over time.
However, just because taking the bus is “right” according to conventional wisdom, doesn’t mean that everybody should be forced to get on one. Just like how you have Ferraris, buses and everything else in-between on the road, there are a wide range of investment strategies outside of the mainstream “at-scale” investment vehicles like mutual funds, PMS, managed accounts, etc.
Momo: The Ferrari Of Investment Strategies
Momentum is a well known Fama-French factor. The problem with momentum portfolios have always been the massive left-tail: when markets are volatile, the drawdowns have been heart-breaking. It doesn’t matter if the portfolio is long-only or long/short, there is no escaping the momentum whiplash.
I've said it before and I'll say it again: if you're using momentum ETFs, check the rebalance schedule. Most won't pick this up until May https://t.co/VKQW1DZDwR
— Corey Hoffstein ?☠️ (?, ?) (@choffstein) March 17, 2021
Then there is the question of rebalancing frequency. To scale a momentum fund, managers need to trade-off transaction and impact costs with being responsive to the market. And that means leaving a fair bit of alpha on the table.
This is the constraint of driving a bus. It can be a fast bus. But it is still a bus.
However, what is true for professional investors and funds is not necessarily true for you, the retail investor.
Do It Often, Do It Better
Most of the early factors were researched at a time when compute power and data were hard to come by. Researchers took the short-cut of using monthly returns to run their analysis because it made the problem more tractable. That set a precedent that is being followed to this day: the monthly rebalance schedule.
The problem with a monthly or a quarterly rebalance schedule is that the market has got a lot faster since the days the papers were written. We live in a world where data is abundant and compute power is a fraction of what it used to be. And trading costs have crashed to a small fraction of what it was 30 years ago.
The world changed.
There is no reason why the market shouldn’t be sampled more frequently.
Some Left-Tails Can Be Docked
A higher frequency approach lends itself to better risk management. It allows for a more responsive position sizing system based on market volatility and the ability to employ “stop-loss” exits on individual positions.
While drawdowns are not entirely avoidable given the nature of the markets, it is quite possible to protect the portfolio against the extremely deep ones. And the deep ones seem to occur at least once every three years, or so.
Avoiding the worst of the drawdowns allows for faster compounding of the portfolio.
Momos are risk-managed, frequently sampled momentum strategies.
Our Experience With Momos
We have been running Momo portfolios for both Indian and US markets for a while and we do it for all three flavors of momentum: Relative, Velocity and Acceleration. We’ll get into the differences between these in later posts but irrespective of the flavor, the “container” within which they run are identical.
The flavors wax and wane depending on the market – there is really no way to quantifiably claim that one is better than the other. In terms of personal preference, I would rank Relative Momentum first, Velocity and then Acceleration. To keep things concise, we show Relative “Momo” Momentum performance below.
US Equities
Indian Equities
Does It Scale?
When we discuss these strategies with professional fund managers, the most common question that comes up is “does it scale?”
And the answer is: No.
It doesn’t scale to professional break-even levels. For eg: for an Indian PMS to break-even, it at least needs Rs. 100 cr in AUM. There is no way the Indian Momos scale up to that level.
But it really doesn’t matter to you, the retail investor. Remember: professional investors are driving a bus, you need not.
Trade-Offs
The market abhors a free lunch. So the next questions is: “What are the trade-offs?”
Risk management is not free. There are always trading costs/taxes that affect the final outcome. But the known-knowns are factored into the performance metrics shown above.
Execution lags. There is always a delay between when the trades are triggered and when the execution takes place. This can be narrowed down by automation to a de minimis.
Compliance. There could be employer, broker or regulator imposed limits on how frequently positions can be churned in certain accounts. Momos would be a poor fit in these circumstances given that any deviation from the model triggered trades can lead to substantial deviation in performance.
Next Steps
If you decide that taking the bus is not for you, then we can help. Have a look at the Momo strategies linked below and let us know if you are interested. We are here to help.
