Siren song - Perceived correlations can be extremely seductive - and extremely dangerous
Professional investors are forever on the lookout for evidence to help support the idea that what they – OK, we – do for a living is a lot more science than art. Anything seen to add more sophistication to how we think about our particular area of expertise is seized upon gratefully, which is why the notion two different sets of data might have a deeper relationship can be so seductive – and so dangerous.
Fun as it may be to flag up the more extreme examples of this concept of ‘correlation’ – as we did on the subject of the apparently life-threatening ramifications of eating cheese before bedtime in Tangled up in blue – other more nuanced lessons may be drawn out of investment-oriented graphs such as the one below.
As you can see, the graph illustrates the relationship between macroeconomic surprises in the ‘G10’ group of the world’s wealthiest nations and two-year forward price-earnings numbers from MSCI and, for the best part of five years after the financial crisis, the two sets of data correlated to a quite striking degree – since when they have not.
Now, clearly there was quite a significant period of time when the market hung on every utterance from a central banker or other policymaker. As such, there will be those who look at this graph and conclude the decoupling of the two lines over the last two years means that asset prices must now be heading for a shock.
To which, here on The Value Perspective, we would reply, that may well happen. If and when it does, however, it will have nothing to do with any correlation between macro surprises and forward price-earnings and everything to do with what the absolute level of valuation of asset prices in the context of history and what that means for the future.
Whether it be correlations or sentiment indicators or whatever else investors believe can help them identify future turning points – and thus make them feel more confident about their decision-making – these things do not have a sufficient level of consistency about them because, to a greater or lesser extent, causality is always in doubt.
So, while we accept correlations may help at the margin by making you think about things in different ways, they also have the potential to mislead you quite seriously. For one thing, you can never be certain when a particular relationship has broken down. Does three months of less or no correlation mean you need to find a new indicator? Or should you wait, say, three years, just to be absolutely sure?
Also, to what extent is your preferred indicator based not on a real relationship but on some nifty data-mining? To use the above graph as an example, how much of the two lines’ correlation is simply down to a shared starting point of 2008? The longer a perceived correlation persists, however, the more investors are prepared to take it on trust.
And if correlations are seductive, they are rarely more so than when the turning points in the two lines are as closely aligned as they are in the above graph – at least between 2008 and 2012. This has echoes of the way bearish investors will want to wait until after a pronouncement from the Fed or the ECB, say, before committing their money while more bullish ones will want to get in ahead of the game.
Nor would we claim to be wholly immune to this here on The Value Perspective. In our day-to-day activity, we continually find ourselves weighing up how some forthcoming results or other corporate announcement might affect a business’s share price. Will the news be good or bad? Ought we to be in or out? Should we sell up now or buy in ahead of the announcement?
Say a company is having a bad time and we think its imminent results will be terrible, however, it does not automatically follow we should not buy the shares. As it happens, after all our years of investing, the most sophisticated conclusion we have reached on this point is, if you are unsure, more often than not the thing to do is to buy half your planned investment ahead of the announcement and half later.
Most importantly, however, you need to be asking yourself if you are going to make money today. In other words, in absolute terms, from today’s share price, do you believe the shares are worth more than they are currently trading at and what are the associated risks? And, if the business’s results are as bad as you feared and the share price halves, what then?
Well, always assuming the risks have not changed dramatically versus a share price that has, then actually this should be a great opportunity to buy more of the company and ‘average down’ the overall price of your entry point. In short, judge everything on its individual merits rather than against a perceived correlation – and we leave it to you to decide how much that comes down to art and how much to science.
Fund Manager, Equity Value
I joined Schroders in 2001, initially working as part of the Pan European research team providing insight and analysis on a broad range of sectors from Transport and Aerospace to Mining and Chemicals. In 2006, Kevin Murphy and I took over management of a fund that seeks to identify and exploit deeply out of favour investment opportunities. In 2010, Kevin and I also took over management of the team's flagship UK value fund seeking to offer income and capital growth.
The views and opinions displayed are those of Nick Kirrage, Andrew Lyddon, Kevin Murphy, Andrew Williams, Andrew Evans, Simon Adler, Juan Torres Rodriguez, Liam Nunn, Vera German and Roberta Barr, members of the Schroder Global Value Equity Team (the Value Perspective Team), and other independent commentators where stated.
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