Noise - Chapter 7
Sources Of Noise: Opinion
Briefly: Opinion
Noise. The opinions that are expressed about markets and securities by the media, the sell-side, and the buy-side are a source of noise.
Conditions. Others’ market opinion is noise if it is incompatible with your process or if it contains no opportunity to capture alpha.
Truth. When you elevate your own market opinion from a plausible scenario to the one and only Truth, you are inviting a whole lot of pain.
Opinions that are expressed about markets and securities are not necessarily noise. What makes opinions become a source of noise is when they interfere with your ability to function at an optimal level.
Optimal functioning in the market domain is when you follow an investment process that you have designed around your competitive edge. Your disciplined following of such a process gives you a chance of outperforming. When someone’s market opinion makes you diverge from your process, that opinion is a source of noise because you become more reliant on randomness and luck rather than intention and skill to generate above-average returns.
A market opinion can be identified as noise if it fails to satisfy these two conditions.
Applicable. The opinion should be applicable to, or compatible with, your investment strategy and process.
Capturable. The opinion should contain information that represents an opportunity to capture alpha.
Applicable
If the opinion points to a compelling investment opportunity but it’s incompatible with the way that you have decided to go about the business of investing your clients’ capital, then making an investment decision based on that opinion means that you have been seduced into diverging from your process and misallocating your clients’ capital.
Applicability is the easier of the two criteria to assess, because it’s mostly a binary question. A detailed research report on a small, obscure company is applicable to you if you are a fundamental investor in small-cap stocks, but it is probably irrelevant and easy to dismiss if you run a large global macro hedge fund.
Capturable
It is more difficult to make a call on whether the opinion represents a form of mispricing that can be converted into realised alpha. The opinion need not point directly to an alpha-opportunity for it to be worth pursuing. It can be a worthwhile opinion if it stimulates your thinking in a way that generates fresh ideas, or if it becomes part of the overall mosaic that makes up a specific investment thesis.
There is relatively little opinion that helps you identify genuine alpha opportunities, and a whole lot that does not. It is a safe bet that a variation of the Pareto Principle is at play here, where 20% of the opinion that you receive accounts for 80% of the value. This makes sense because genuine alpha-opportunities are rare. The opinion would need to contain some new information or unique insight that is not yet reflected in the market price of the security or asset class, and the opportunity would need to satisfy a list of risk-management requirements, such as liquidity and duration.
If the opinion is compatible with your investment process, but there is no alpha to be gained by pursuing it, then it is a distraction that will cause you to misallocate your cognitive resources. Even if the opinion is an original conception that is crisply articulated, if it is neither applicable nor capturable then it is just pretty noise.
There are three camps from which market opinion emerges. Some of the opinion from each of these camps might satisfy the conditions of applicability and capturability, but the majority will not, and this makes it a worthwhile practice to have as your default position that each camp is a hostile force intent on hijacking your attention for their own ends. Many of these folks do not care one jot whether their opinion helps you to capture alpha. Their primary objective is to capture your attention as feedstock for their own machinery. They need you, or a sufficient number of people like you, to stay in business; they do not need you to beat your peers or your benchmark.
The three opinion camps are:
Media. Financial journalists and other market commentators.
Sell-Side. Economists, strategists and analysts.
Buy-Side. Fund managers like you.
Media
No matter what the specific type of media, TV or print or social, most commentary is about what has already happened and, as a general rule, if it’s in the news, it’s in the price. A cub reporter who has been assigned to write the daily market wrap will have to come up with a single-phrase explanation of the day’s 20 bps move on an index of 500 stocks, and will spuriously assign simple cause to effect.
In this time of media saturation, market commentators who do not have some unique insight must do something to compensate for that deficiency. They need to dial up their opinion in some way to be heard above all the other noise: their views will need to be more extreme, their story more compelling, their conclusions more certain. These are tactics that are employed to capture your attention, and they are hostile to your endeavour to generate alpha.
The market opinion that you get from TV channels like CNBC and Bloomberg TV is like a mild form of crack, designed to give you a little rush by creating the impression that you are in the middle of the action. You know that having the TV on isn’t good for you or your performance, but it’s on anyway. The shows are anchored by breathless women with good teeth or frowning men in bowties who preside over a conveyor belt of earnest talking heads. Even though some of those talking heads are respected members of the sell-side and buy-side communities, their opinion in the media gives you zero advantage over your competitors. The TV anchors want you to surrender your precious cognitive resources to them and in return you may just get a momentary rush. It’s not a good deal.
Example: FrontPoint Partners
FrontPoint Partners was one of a handful of firms that was able to profit from the meltdown in the subprime mortgage market in 2007. The firm’s fund manager, Steve Eisman, had put on a massive short position in collateralised debt obligations, but in early 2007 the position was not playing out as he had hoped. Despite growing evidence of problems in the subprime market, credit spreads had actually tightened and virtually every market commentator in the media was bullish.
The firm’s head trader, Danny Moses, was concerned that the commentary coming from the TV in the firm’s trading room would have the effect of prematurely shaking them out of their short position. He said, “It became very frustrating that they weren’t in touch with reality anymore. If something negative happened, they’d spin it positive. If something positive happened, they’d blow it out of proportion. It alters your mind. You can’t be clouded with shit like that.”
So he decided to do something about it: “We turned off CNBC.” And removing this corrosive source of noise helped them to stick with their short CDO position until the subprime market eventually fell apart, and they were able to post a gain of 81% for 2007.
As effective as flipping the switch was for FrontPoint, a wholesale tuning out of media is not a good way to deal with this particular source of noise. Useful information almost always comes wrapped in layers of noise, and so when you reject the layers of noise, you can end up losing the information too.
This seems to suggest that noise management is a matter of refining your filters so that you tune out the dross and get the good stuff. That’s a good practice, but you need to be careful about the filters that you use, so that you don’t inadvertently create an echo chamber where you are soothed by hearing your own opinions being reflected back to you by others, where you mistake high quality commentary for what you already think, and you don’t get any dissenting opinion to give you a reality check. This is classic confirmation bias, where an error in calibrating your media filters can have the unintended effect of transmuting chronic noise into latent noise that leaves you vulnerable to nasty surprises. This is what happened to many in the industry in 2016 when they were shocked by the outcomes of both the UK’s Brexit referendum and the US presidential elections.
Sell-Side
If the sell-side community is to be something other than a source of pure noise to you, the legion of strategists and analysts need to tell you something that both fits your investment process and which can be translated into alpha. If they don’t, their opinion is at best a distraction.
The quality of sell-side research has historically been undermined by the existence of two other parts of the investment banking business, both of which create conflicts of interest. Ironically, changes in regulation to lessen these conflicts, as well as changes in technology, have reduced the value of the sell-side.
Trade Execution. The soft commision structure, where research was indirectly paid for by fund managers placing trades through the brokerage arm of the investment bank, meant that a large quantity of lesser-quality research was produced. But as the pre-MiFID economics of sell-side research has changed, the shotgun approach is less frequently used. Now that fund-management firms are starting to pay directly for sell-side research, you are more sharply focused on the applicability, and the quality, of the research that you receive.
Capital Raising. The porous Chinese walls between analysts and investment bankers meant that analyst recommendations on stocks were a form of currency for attracting companies’ lucrative investment banking business. While the conflicts of interest are today perhaps less egregious than at the time of the Dot Com Boom, you would be well served to remember that when sell-side analysts put a recommendation on a stock, they don’t necessarily mean exactly what they say.
If you are sufficiently cynical or experienced, you probably ignore sell-side recommendations and you might use their analysis and predictions to give you a sense of anticipated trends in fundamentals. The bad news is that the prediction track-record of communities of experts, including the sell-side, is no better on average than random guessing. Philip Tetlock has convincingly shown that the forecasts of the average expert are about as accurate as those of a dart-throwing chimpanzee.
The old joke is that there are three rules of forecasting:
Don’t give a specific number.
If you do give a number, don’t give a date.
If you do give a number and a date, don’t come back.
Sell-side strategists do not find this amusing. A few strategists have built lucrative careers on the basis of a single extreme prediction that, luckily for them, turned out to be correct. Most other strategists realise that this is a very risky way to earn a crust, so they play it safe and don’t stray too far from the herd. The result is that most sell-side predictions represent the consensus and therefore offer no direct alpha-generating opportunities, while a few forecasts are wild haymakers that rely heavily on luck.
But despite these very obvious shortcomings, the sell-side can add value to your quest for alpha. You need to know what the consensus is if you want to take a non-consensus bet, and the sell-side community provides this valuable service. And the more extreme predictions can be valuable if you use them as a stimulus to challenge your own thinking. Beyond that, though, virtually everything else from the sell-side is noise, no matter how confident or eloquent the opiner. You need to be careful to not conflate confidence with expertise or insight. When no-one knows what the future looks like, you need to beware of those who pretend to know, and especially beware those who believe that they know.
When you are overconfident, you’re flirting with danger; but when you rely on someone else’s overconfidence, the odds are heavily against you generating alpha. If you agree that the sell-side as a whole is unlikely to be a source of alpha, you would be better off viewing this camp as merely a more informed version of the media, one level more useful than entertainment.
Buy-Side
It can be useful to know how your competitors on the buy-side are positioned. Even better, though, is if you have a decent idea of how they might treat those positions if there were a spike in their noise levels. First prize would be if you could identify a catalyst for an abrupt increase in that noise. Then you would be in a position to pick off your competitors’ noise-induced decisions.
Example: Omega Advisors
Leon Cooperman was one of the longest serving hedge fund managers in the world, having launched his hedge fund in 1991 and eventually converting it into a family office in 2018. His tenure was not always free of controversy. In September 2016 the SEC alleged that Cooperman had engaged in insider trading and that they were seeking an $8 million fine and a five-year ban from the industry. In May 2017 Cooperman agreed to pay a fine of $4.9 million to settle the charges, while admitting no wrongdoing.
But these were by no means the only costs that Omega had to bear. The firm was also hit by significant redemptions from clients who were spooked by the SEC’s charges. In the time between the charges being laid and the fine being paid, Omega lost $2 billion of its $5.1 billion assets under management due to redemptions, which represented more than half of Omega’s outside money, the balance being Cooperman’s own family money.
The third and least obvious cost was that the charges levelled against Cooperman gifted his competitors with an opportunity to take advantage of his troubles by front-running his probable liquidations. Cooperman’s competitors will have known that the SEC’s charges would put pressure on his investors to pull their money, and that Cooperman would have to sell some stocks to fund these redemptions. And they would have had a fair idea of which stocks he’d have to sell by simply glancing at Omega’s compulsory filings with the SEC.
You can exploit a short term dislocation when you know how your competitor is positioned and what their actions are likely to be, but such an opportunity to take advantage of a competitor’s troubles is a rare thing. Perhaps more likely is that you will be the hunted rather than the hunter. If your competitors go out of their way to help you form an opinion about how they are positioned, you might want to treat that intel with a little suspicion. The chances are better than even that they want you to get excited about their story so that you bid up their position and provide the liquidity for their exit. Very few of your competitors would be so naive as to hand you their investment ideas if it did not serve their own interests. So when the fund manager that your clients see as your closest competitor appears on TV or radio or in the paper, it is more than possible that you are his real intended audience. He is probably talking his book and his opinion must be treated as dangerous noise.
But there is someone whose market opinion is potentially more lethal than that of your biggest rival, and that person is you. Your own opinions can seriously undermine the quality of your decision-making. Of course, you have to formulate opinions about stocks and markets, and some of those opinions need to be strongly held in the face of general disagreement; that’s part of your job, it’s part of taking a non-consensus view to capture alpha. But there is a point where your opinion becomes too firmly held, and becomes something to be defended at all costs, and sometimes one of those costs is the loss of your ability to admit that you are wrong.
When you repeatedly express a strong opinion, perhaps to members of your team who don’t yet see what you see, or perhaps to clients who are jumpy after a couple of poor months, or perhaps because you’re really confident that you’re right, that opinion starts to look like the one and only truth rather than one of a number of plausible stories. When your opinion morphs into being the Truth, then you will have crossed the threshold that separates your need to be right from your desire to generate alpha, and these two things are by no means identical. If things don’t pan out as you expect but you keep clinging to your cherished story, you will keep fighting when you should flee, and that’s an invitation to a whole lot of unnecessary pain.
Example: Pershing Square Capital Management
In 2014 Bill Ackman had good reason to be confident about his ability to pick stocks because his Pershing Square was then the best performing large hedge fund in the world. In mid-2015 Ackman was featured at the Sohn Investment Conference in New York where he disclosed that his number one stock-pick was a company called Valeant Pharmaceuticals, which he described as an early-stage Berkshire Hathaway.
All too soon thereafter the stock price peaked and began to unravel after being accused by politicians of price-gouging, and accused by a short-seller of accounting fraud. Pershing Square’s investors were naturally concerned about these developments, so Ackman hosted a three-hour conference call in which he defended his decision and strongly expressed his commitment to the fund’s position. At around this time, Ackman added meaningfully to the existing position in Valeant. In March 2016, with the stock down about 70% from its 2015 peak, Ackman again increased his commitment to Valeant by joining the company’s board and initiating a significant restructuring of the company’s management and its balance sheet.
But a year later, in March 2017, after having been a very public and forceful defender of his own opinion, Ackman was finally forced to capitulate. He publicly acknowledged that his investment decision had been a mistake, and Pershing Square sold all of its holding in Valeant, with the stock down 95% from its peak and Pershing Square’s investors a few billion dollars poorer.
This is a very easy error to make, and even the most hardened pros fall prey to their own opinion because they place a high value on consistency. Sticking to your guns is an important attribute but, as with most things, when taken to excess even a great virtue becomes a vice. Consistency is almost a moral imperative for some fund managers, which is why (unconsciously) you might rather lose money than be accused of inconsistency.
It’s a very tough thing to find the best balance between having the mental fortitude to back your non-consensus ideas and becoming so wedded to an idea that you can’t see disconfirming data. When you become too attached to your thesis, which often occurs through forceful and convincing repetition of your opinion, you become prone to confirmation bias, where any additional “analysis” is simply an elaborate way of justifying your prior decision. Part of your job is to navigate your way between courage and flexibility, both of which have their noisy, malevolent sides.
What you might infer from this is that all opinions should be ignored as a way to protect yourself against the evils of noise. The difficulty with such a strategy is that you will certainly cut down the noise, but you will also snuff out any chance of getting useful information. You need to actively encourage opinions that challenge your own views, and that should itself be part of your investment process. Even market opinions that are noisy can contain some information, although the existence of information is difficult to determine, especially ahead of the event about which the opinion is being expressed. This is tricky territory. You need to be open to opinion so that you can gather new information, but not too open or you will be swamped by noise. And you need to be somewhat closed to opinion so that you don’t get overwhelmed, but not too closed or you will be beaten by your competitors. Who said your job was easy?
References
Lewis, M. (2010) The big short: inside the doomsday machine. London: Penguin Books.
Tetlock, P. & Gardner, D. (2015) Superforecasting: the art and science of prediction. London: Random House Books.
Article in the Financial Times on 18 May 2017 by Kara Scannell: ‘Cooperman settles insider trading charges for $4.9m.’
Article in Fortune on 13 March 2017 by Stephen Gandel: ‘Bill Ackman’s Valeant exit is an enormous loss for the faded hedge fund star.’