From the October 2008 issue of Wealth Manager Web • Subscribe!

October 1, 2008

NOISE

In 1965, two astronomers in Crawford Hill, N.J. were monitoring radio emissions from the Milky Way. A low and annoying hum interrupted their work. They wondered, could it be coming from the nesting pigeons that were leaving droppings inside their antenna? It turned out the birds were blameless, and that the cosmologists had actually been observing the cosmic background radiation of the universe.

In financial markets, low-level noise can be just as distracting. Some of it may prove to be viable information (just as those scientists used the background signals to confirm the Big Bang theory). Other sounds are meaningless or even misleading--more like the pigeons. Recognizing one from the other is one of the most difficult investment challenges, and one where advisors can add valuable insight.

An Elusive Definition

It is not easy to define economic noise, and it's even harder to filter it out. It is frequently difficult to distinguish it from 'information'--i.e. data that actually serves to identify a trend or fundamental value. Michael Edesess describes financial noise as the "error the market makes in estimating a fair price." Edesess, who is chief investment officer at Fair Advisors in Denver, describes how each security has a real value, while its market value consists of an estimate of that value with an error. The market value is the best estimate of any asset today, he believes. If that price is wrong, the degree to which the market is mistaken is noise and will iron out eventually.

The economist Fischer Black was first to highlight the term among academic audiences when he delivered the presidential address to the American Finance Association in 1986, and entitled his paper "Noise." In his discussion of market equilibrium and fair value, Black described how traders often act on noise as if it were real information, attaching meaning to insignificant data. As a result, said Black, prices drift away from fundamental values. That suggestion startled his audience. Until then, Black had espoused the notion of a strongly efficient market that incorporated all available information at any given time. Now he was modifying that view! Noise, he postulated, causes prices to wander from a factor of one-half- to two-times fundamental value, and even information traders who have accurate knowledge cannot bring prices much closer to values.

Examples Abound

Consider the barrage of media chatter--in particular the chorus of talking heads who analyze securities, recommending that their audiences buy, sell or hold. Although occasionally a very influential analyst may precipitate a warranted shift in a stock price, most of the babble soon cancels itself out. A 24-hour news blitz of television and Internet reports tempts markets to overreact. "We often see that on a Friday afternoon, when the market does not have quite enough time to interpret a particular item," notes Ezra Zask, director of the securities practice at expert consulting firm LECG in New York. For instance, military maneuvers or verbal saber rattling sometimes lead to unfounded speculation about an imminent attack. Usually, nothing takes place, and the noise dies down by the following week.

In the upward direction, investors cannot resist record-shattering moves--especially those that surround round numbers. Who can forget the hoopla of the 1990s as the Dow Jones Industrial Average took out each new level of 1,000 points? More recently--after causing a sensation when it closed over $100 a barrel last January--oil has attracted extra attention for new record highs. These records do not deserve so much attention, says Matt Johnson, portfolio manager at Quantum Capital Management in San Francisco. "It is extremely likely that you will get a new high the day after you have just had one."

Speculation over Federal Reserve actions is yet another example. Fed Chairman Ben Bernanke has tried to address the problem by increasing the transparency of his communications, but the science of interpreting Fedspeak is alive and well. Unemployment data produce the wildest gyrations in the bond market. After Bernanke delivered a June 4 commencement speech at Harvard--with references to containing 1970s-style inflation expectations--the market abruptly braced for a fresh series of higher rates.

"You can take advantage of that noise to implement a longer-term view, if you believe those expectations are too dramatic," suggests Andrew Burkly, market strategist at Brown Brothers Harriman. While the press has been whipping up memories of 70s-type runaway inflation and pain at the pump, Burkly maintains that the data does not support that outcome. "People are extrapolating from headlines of food and fuel and commodity inflation. They forget that home and auto prices are deflating, and those are the two main areas of consumption."

Ken Homan, portfolio manager at Springfield Trust and Investment in Springfield, Mo., agrees that inflation fears have been "overblown." The true picture should incorporate labor costs and housing, which play a more significant role. The Federal Reserve is doubtless more focused on labor costs than the price of eggs.

"I try to ignore the political chatter that deals with the Presidential election," Homan adds. The eventual outcome of the election will have relatively little impact on corporate earnings in any case, and most of the candidates' current economic positions will not even be implemented if they win. It is true, says Homan, that their tax proposals are more likely to see the light of day. Most other economic pledges deserve a proverbial grain of salt.

Human Nature

We are perpetually "fooled by randomness," as bestselling author Nassim Nicholas Taleb explained in his 2001 book of that title.

"Because it is people's nature to look for meaning, they are inclined to seize on patterns and put too much weight on them," explains Hersh Shefrin, professor of finance at Santa Clara University in California.

Most people read too much into recent historical trends and extrapolate from them as if their pattern could be repeatable over long periods of time. "Customers who watch the market closely overreact to ups and downs, and try to interpret from recent events what will happen going forward," Homan notes.

A herd mentality can reinforce misleading interpretations. "Noise usually washes out, like a ripple tank where different waves move around to cancel each other," as Shefrin puts it. What starts as noise can take on more dangerous implications, morphing into bubbles. Strictly speaking, a phenomenon like the technology boom of the late 1990s should not be classified as noise. Although it is a stark example of the market's failure to price the Internet stocks correctly, "it does not adhere to the assumption that miss-estimating by plus or minus will lead to an average error zero," says Edesess. The Internet mania traveled for years in one direction: up.

It is another common temptation to form predictions based on small data sets. "Most clients who are responding to noisy data want to take action," reports Tim Phillips, CEO of Phillips & Company in Portland, Ore. He might feed them back some of their recent predictions, which he has carefully tracked, to help "de-bias" them. He asks his clients, "What exactly is your source? Is it relevant? Is it accurate?" To make matters worse, investors tend to seek even more confirming evidence for those judgments they have based on mere noise. "The danger is that people get vested in their own opinions," Phillips notes.

Investors tend to prefer precise and specific forecasts over accurate information. It might be an exact prediction to announce that oil will rise to $200, but what matters is whether it is accurate. An element for distinguishing noise from genuine context is the reliability of the data and the medium. In the case of oil, much of the surrounding data is unreliable, including supply, capacity in the ground, reserves and other factors. "How many barrels of oil are being shipped on the open seas right now?" asks Chris Sheldon, director of Investment Strategy at BNYMellon Wealth Management. "We basically use binoculars to figure it out!"

Certain traders have been able to exploit pricing opportunities by carefully studying underlying fundamentals. Although some non-noise information can enable a good trader to make successful bets, the degree of opportunity is overstated. Investors, like all people, are more often subject to overconfidence.

Time Horizons

One man's noise is another man's information. The context of the time frame for investing differentiates the two types of data. Suppose you are investing for an endowment or pension plan on a 20-year investment cycle or generational level; some noise could theoretically last five years or so. In the most extreme case, equities tend to rise over the long term. "In that context, everything else would become noise except for the upward bias!" says LECG's Zask.

Over the past year, the subprime and credit crises, along with the real estate meltdown, have buffeted markets. Phillips, who advises a number of institutions and philanthropic endowments, knew it was critical to help them keep focused on their long-term investment mandates. He describes how his clients were overreacting to inconsequential short-term data. Many, unnerved by the unfolding crises, wanted to move large chunks of their portfolios to cash. He dissuaded them by reminding them that cash investments would not even allow them to fulfill their mission and spending requirements.

For those with a shorter outlook, the noise is of a different caliber. Hedge funds may be shifting between asset classes on a medium-term, or quarterly basis. At the most ephemeral level, consider the statistical arbitrageurs, whose goal is to insulate noise from trends, often on a second-by-second basis. Using mathematical algorithms that seek mean reversion, they may hold positions for only a few minutes. As they receive their continuous stream of data, they attempt to impose order on it. "What is left behind is the fundamental move," Zask explains.

In shorter-term trading, it is important to identify how much information has already been discounted. Investors place undue weight on hearing or reading about events, yet by the time they are aware of them, the occurrences have probably been digested into prices. "Surprise is what drives the market, rather than what is already recognized," says Sheldon.

Here is where a wealth manager can add value. It takes considerable resources to pinpoint the driving factors alongside the discounted news. An advisor can offer the resources, experience and context required to gauge how much the market is already cognizant. "Take the 2008 rise in oil prices," Sheldon suggests. "Oil prices are rising, but the market already knows that."

There is another dimension to factor in. The expert's skilled assessment may not be enough. Never mind your own assessment; where is the market paying attention? The concept of the Keynesian beauty contest comes into play. One does not win by choosing the prettiest face, but rather by anticipating what the average opinion expects the average opinion to be. In other words, it is not sufficient to assign share prices based on fundamental values, but rather on what others will perceive them to be. During the 1980s it was fashionable to cue to the money supply numbers. These days, few investors pay much attention to them, and they no longer move prices.

Wheat from the Chaff

Having addressed time frame and strategy, the next challenge is how to sort out noise from useful information and rank its validity. Access to information per se no longer delivers the benefits it once did. "High-net-worth investors today have so much more information than institutions did 20 years ago!" says Sheldon. The bear market declines in the 1970s took place "silently," he adds, since in those days, not everyone was sitting next to a Bloomberg terminal.

The flip side, however, is that now every bump and wiggle can attract too much attention. Markets still react to GDP reports--despite the fact that many are old news after two or more revisions. That is not to say that pieces of evidence should be ignored. It is critical to seek clues for either slack or inflation pressure in the economy. The key to success here is to assemble the various elements together in a holistic mosaic which should give an indication of any salient shifts.

You would not want to make long-term decisions based on a sole measurement, such as monthly employment reports, durable goods or capacity utilization. The individual numbers are too unreliable and subject to revision. However, taken as an entirety, they can provide a pattern, or trend. Moreover, it is easy to distort a specific metric such as the ABX index that tracks subprime mortgage backed securities: It is the only game in town. Even LIBOR has been subject to recent scrutiny. "For years, everyone relied on it, but few knew exactly how it was set," says Sheldon. Or one bad apple can taint other stocks in a sector through guilt by association. For example, this past spring, negative developments at Merck unfairly cast a pall over other pharmaceuticals.

Burkly suggests separating regular monthly data into several tiers that can be ranked in order of significance. Among the top-tier data, he cites those economic indicators released during the first week of each month, including the purchasing managers' index, the consumer price index, unemployment numbers and auto sales. Factory orders and durable goods constitute a middle tier. "As we float through the month, we get secondary surveys and confidence measures," Burkly continues. Many studies confirm that those are lagging indicators which do not correlate well with fundamentals. Yet they still tend to propel markets temporarily, especially the University of Michigan consumer sentiment index. How valid is it? Often, respondents claim they are not confident, but nonetheless still keep spending.

Noise--disguised as institutional data--can confuse your market philosophy. "Pointing out counterintuitive historical data is a great way to insure clients ignore the noise and focus on their long-term investing goals," says Phillips. According to Ned Davis Research data from 1960 until 2007, when GDP has run over 6 percent, stocks have lost 4.6 percent a year; with economic growth between 1 percent and 6 percent, stocks have increased 8 percent annually; and when GDP crept along below 1 percent, equities soared 13.1 percent. Lower interest rates often provide a tailwind, despite the gloomy rubble from media commentators.

In general, volatility is the type of noise you will most frequently need to address with your clients. Quantum Capital's Johnson suggests it is important to prepare them up front, before the volatility becomes a roar. Explain and reinforce early on how markets typically behave over multi-decade periods, rather than in the midst of a rout.

Of course, especially during turbulent episodes, noise will make anxious clients start to question their commitment to their investment disciplines. Never, ever be dismissive of their information and opinions, Johnson urges. Don't even use the word 'noise.' Instead, revisit any specific issues carefully and methodically. Explain why a particular position was purchased for the portfolio and why it should remain. Remind them how the uncertainty created by negative data offers a window of opportunity.

The market pays for bearing risks and rewards all the more handsomely when noise intensifies fears and insecurities. Those are the times to take advantage of the cross currents, to implement longer-term views.

Vanessa Drucker, who used to practice law on Wall Street, wrote about volatility in the January Wealth Manager.

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