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| Nicholas Colas |
By Nicholas Colas
Every year, I drive to Memphis for Thanksgiving with my in-laws, a welcomed break from the day-to-day rigors of following the capital markets. Once you get southwest of Washington DC, essentially everything changes. The traffic thins out and becomes a combination of Ford and Chevy pickups and semis rather than the imported cars and SUVs of the East Coast. Roadside signs promote local restaurants rather than national chains. As you drive deeper into the South, huge white crosses note the location of local churches. You see an occasional freshly-killed deer strapped to a car roof or loaded in a trailer along with an off-road quad. The signs for local guns stores appear frequently on the side of the road. I usually stop at one or two along the way. The fellows behind the counter get a real kick out New Yorker visiting their shop, even if they aren’t such big fans of our Mayor.
With many hours to kill on the drive, I began to ponder how much rural culture has in common with the current investor psychology. At first blush, Wall Street and backwoods America may not seem to have much in common – the whole 1% versus 99% thing – but people are people everywhere and how they respond to uncertainty is a matter of DNA, not disposable income. Once I got home on Sunday I dredged up a copy of The Foxfire Book, first published in the 1970s to much popular success. The book is a collection of stories and recollections of older people living in the rural Appalachia of northern Georgia in the 1960s. Their experiences of growing up during the Depression run from everything you need to know about how to build a log cabin that will last 100 years or more to instructions for making high quality moonshine without being discovered by the local authorities.
Patterns of life in the rural Georgia of the 1930s to 1960s and the state of capital markets at the moment share one common thread: existential risk. The stakes are much higher – life or death, really – if you live deep in the woods, of course. Bad planning plus rough weather, for example, can mean exposure and starvation. But human beings respond to risk in much the same way whether they are sitting on a trading desk wondering what is going to happen to the euro or on the front porch of a cabin watching a bad storm make its way to their doorstep.
Take, for example, the practice of “planting by the signs,” described in The Foxfire Book as using astrological and astronomical (yes, there is a difference) signals to govern when you plant or reap crops and tend to your animals. Sowing a field of corn, for example, should be done in the first half of the lunar cycle when the moon is “growing.” Clearing out a field of weeds and brush should be done in the waning part of the moon’s cycle, presumably due to the same logic. No planting on Sunday: not because of the Sabbath, mind you, but because it is a barren, hot day – like the Sun. Cut timber on the waning part of the moon’s cycle and it will dry without warping. There are pages and pages of such advice in the book, based on everything from the zodiac to the observed movement of stars and planets.
There should be no reason why any of these programs should work when viewed through the critical lens of the scientific process. Yet these traditions held up to the test of time in a rugged environment where efficiency and economy are critical to survival. Why? The chroniclers in charge of the “signs” chapter had a theory – those who “Plant with the signs” tend to be hard-working, process-driven farmers. Paying heed to traditional methods means they are more likely to do other things correctly – weed regularly, fertilize at the appropriate time, and diligently keep scavengers away.
As I reread the “Signs” chapter, I couldn’t help but think that technical analysis is essentially Wall Street’s version of “planting by the signs.” I am not aware of a single academic study that proves there is any validity to the notion that looking at price charts yields any systemic outperformance. Investors tend to use it because “everyone else does, so it becomes self fulfilling,” or similar explanations. To me, the diligent use of technical analysis shows that a money manager wants to cover all his/her bases, just as the rigorous farmer will plant with the signs as well perform the scores of other tasks necessary to bring in a successful harvest. It may not help, but it doesn’t hurt either. And if the farmer/investor is just as diligent in other aspects of their process, it should be no surprise that they deliver consistently good results.
And I don’t just want to pick on the technicians. The notion that a price to earnings ratio has any power to predict stock price movement should be held with a similar level of suspicion. That’s because that metric leaves out so many important factors in corporate performance, such as return on invested capital, potential growth in new capital, or even management competence. Yet we all look at the P/E ratio on a stock with the same reverence that a rural Georgia farmer might ascribe to the phases of the moon when considering when to plant spring corn.
Another aspect of old-time rural life is that there are very few “Specialists” – the average person had to be able to perform a wide variety of useful tasks. Men had to know basic farming practices, how to hunt for fresh meat or kill scavenging animals to protect their domesticated stock, woodworking, and how to slaughter animals without contaminating the meat. Women were even more skilled across disciplines, doing all the cooking and food preservation, making clothes and soap, and tending to the garden. The few specialists that seemed to exist tended to focus on home or furniture building – items that required significant resources and where real craftsmanship delivered a quantifiably better product.
Markets allow people to specialize when things are predictable – that maxim applies to basic agricultural societies and Wall Street alike. When that stability is lacking, everyone pitches in to get the job done. And that is right where we are now with respect to capital markets. Existential risks, such as the uncertain future of the Euro or the still-tenuous economic recovery in the United States, mean that asset price correlations are high and likely to remain so. The successful investor will have to develop a point of view on a range of macroeconomic drivers since it has become so difficult to make excess returns with stockpicking alone. That investor will have to develop a point of view about European sovereign debt viability one day, the sustainability of Chinese economic growth the next day, and the price of copper the day after that. There is no time to specialize.
The last behavioral commonality I found as I perused Foxfire and thought about rural life and investing has to do with the importance of planning and personal responsibility. Much of the Appalachian population discussed in the book came to the U.S as Scotch-Irish – a strongly independent group of Protestants with a profound distrust of government and the thrifty ways for which the Scots and Irish are still known. They wasted nothing – one story in the book relays that cooked possum head was a popular treat offered to especially well-behaved children, for example. Every part of the animal was used, and everything harvested from the fields ended up stored, canned, dried, or fed to the animals.
The analog to investing is the still-rising importance of risk management. Waste not, want not, as the saying goes – and managing net exposure as well as draw downs is essentially the same as using the whole pig. Or at least not letting it escape before it can be slaughtered.
Any comparison about the current difficult state of investing is supposed to tell us when things will get “back to normal.” The last lesson that the Appalachian farmer might have for the Wall Street trader is that normal is entirely subjective. The repeating theme in Foxfire is that everything in life is largely what you make of it. Success comes down to process and practice. If some notion of normalcy does eventually come to the fore, those habits will still be useful. And if it doesn’t, you just keep going with the same program.
Nicholas Colas is the chief market strategist at technology and trading firm ConvergEx Group.
