Several approaches for generating alpha have been proposed and practiced by investment professionals in equity investment. A book I have been reading has confronted the age-old debate between the proponents of fundamental analysis and technical analysis, and has in fact added a third dimension - quantitative analysis. A very well informed and thought provoking set of ideas I must say!
As per the author, the three approaches focus on three different characteristics of the stock market. The fundamental analysis has depth but is narrow in its coverage, it relies on the ability of human brain to process diverse set of qualitative and quantitative factors simulatenously while still accounting for the effect of the general economic context on stock market performance. The technical analysis relies on the behavioral interplay amongst market participants - reflected in the price movement of various stocks and indices. It has the brevity of parameters - i.e. just the price of the stock over time - and can claim to deal with what ultimately matters - the demand for and supply of each stock in the market, as indicated by the price movement. The quantitative analysis is entirely backward looking, highly scientific and thus replicable and has the advantage of breadth. It can claim to look at the widest set of opportunities since it is not limited by the bandwidth of any one human being.
Is there a winner? I guess not. Investors have made and lost money while investing with each of the three approaches on a standalone basis. Each has some flaws and some advantages.
Fundamental analysis is intellectually appealing at the surface. It directly asks the question - what is the value of a stock and how does it compare with its price. However, as one delves deeper, one realizes that the estimate of value of the stock is as good as the assumptions made in arriving at it. The model can be tweaked in so many different ways to arrive at a given 'value' that the error term in estimation is often larger than the supposed gap between the 'value' and the 'price'.
Technical analysis captures the moods of the decision makers quite accurately. One can claim that whatever be the value of a stock, if the market participants agree on a different level for the price of that stock and stay there, one can never make money using the concept of value. The only way out is to let the story play out over a number of years through which the dividends paid by the company actually make up for the price paid for it as per the value model! That can be over 10 years in most cases. The problem with technical analysis however is that it is oblivious to the factors causing the prices to move. Analysing the chart of any stock price movement can never help one predict an improvement in its margins owing to say a regulatory change. The technical analyst will often be the last one to join the party in case of shifts in valuation driven by factors like this. Technical analysis then works only in still waters - not a good limitation when one is looking to generate market beating returns.
Quantitative analysis is too generic a term to be evaluated as a single strategy. However, if one assumes that a mathematical model based on historical data and analysis is used to predict the attractiveness of stocks or points of entry into the markets, the limitations of quant strategies become clear. In a manner similar to the technical strategies, quant strategies cannot account for the shifts in valuation. They also suffer from overgeneralization of certain trends. The benefit of quant strategies however lies in their ability to beat the market in terms of returns. In this respect they are better than fundamental or technical strategies which are in some sense trying to generate high positive returns. Their focus is typically not as much to beat the market as it is to generate good returns. When one restricts the mandate to beating the markets, one can start seeing the advantages of the quantitative strategies. Ultimately, as I have argued in another post ("Index Investing and Quantitative Strategies") on this blog, market returns as reflected in the performance of an index, are a special case of an oversimplified quant strategy. If one were to take some identifiers of good stock market performance from both technical and fundamental analysis, one can hope to beat the markets more consistently than either of the other two strategies.
One can almost go back to the Hegelian dialectic of thesis, antithesis and synthesis in the above debate. The thesis is 'fundamental analysis'. The anti-thesis is 'technical and quantitative analysis'. The synthesis then is a integrated approach which combines best of all the three! Something I have started working on thesedays.
Sunday, January 02, 2011
Sunday, December 26, 2010
Movie review - Rashomon
Holiday season is upon us and I thought I would take a little break from the world of finance and economics to wander off into some interesting territories. I had bought this collection of Akira Kurosawa movies. Of this I finally got around to watching Rashomon. It is a great movie no doubt. Here's a humble attempt to analyse it.
The movie is narrated by a wood-cutter to a common man who has come to share a shelter named Rashomon during a heavy downpour. There is a priest as well. It transpires that the woodcutter and the priest had come to testify in a court for a crime of rape and murder by a bandit against a samurai and his wife. The woodcutter however recounts (from what he hears at the court as told by the witnesses) three different stories to the commoner - each of which are different in their reasons and details. These are accounts of the crime as told by the bandit, the wife and the samurai. The starting set-up, ending state and some of the major chunks of events are same in each story. The motives and specific actions by each of the three however are quite different.
Just as they are wondering which of the stories is correct, the woodcutter goes further to narrate his version of the story as well - supposedly the closest to the truth. As it turns out, the best availble version of the 'truth' has its own flaws as well. The commoner represents the utterly cynical worldview while the priest stands for the idealist variant. The woodcutter seems quite disturbed by his observation of the limitations of human nature.
The central theme of the movie is quite disturbingly accurate of the limits of the truth available to human beings. For one, it focuses on how truth gets deformed by the individual agendas and aspirations the observer has. This is shown through the three stories of the bandit, the samurai and the wife. Secondly the movie goes into the more disturbing exploration of whether there is any absolute truth whatsoever which is without any coloring by the observer. This is brought out in the slightly distorted version of the events produced by a supposedly unbiased woodcutter. One is almost tempted to revisit the principle of quantum mechanics that the observer invariably influences the observed and thus can never provide the accurate description of "things as they are". Rashomon seems to bring out a similar intertwining of the observer and observed in the moral plane.
The movie is narrated by a wood-cutter to a common man who has come to share a shelter named Rashomon during a heavy downpour. There is a priest as well. It transpires that the woodcutter and the priest had come to testify in a court for a crime of rape and murder by a bandit against a samurai and his wife. The woodcutter however recounts (from what he hears at the court as told by the witnesses) three different stories to the commoner - each of which are different in their reasons and details. These are accounts of the crime as told by the bandit, the wife and the samurai. The starting set-up, ending state and some of the major chunks of events are same in each story. The motives and specific actions by each of the three however are quite different.
Just as they are wondering which of the stories is correct, the woodcutter goes further to narrate his version of the story as well - supposedly the closest to the truth. As it turns out, the best availble version of the 'truth' has its own flaws as well. The commoner represents the utterly cynical worldview while the priest stands for the idealist variant. The woodcutter seems quite disturbed by his observation of the limitations of human nature.
The central theme of the movie is quite disturbingly accurate of the limits of the truth available to human beings. For one, it focuses on how truth gets deformed by the individual agendas and aspirations the observer has. This is shown through the three stories of the bandit, the samurai and the wife. Secondly the movie goes into the more disturbing exploration of whether there is any absolute truth whatsoever which is without any coloring by the observer. This is brought out in the slightly distorted version of the events produced by a supposedly unbiased woodcutter. One is almost tempted to revisit the principle of quantum mechanics that the observer invariably influences the observed and thus can never provide the accurate description of "things as they are". Rashomon seems to bring out a similar intertwining of the observer and observed in the moral plane.
Wednesday, December 15, 2010
Current account deficit - how big a deal?
Several observers have expressed concern about India's rising current account deficit. In recent months, the deficit has indeed been on rise.
However, contrary to popular perception this need not cause the same degree of alarm it used to say 10 years ago.
In general a widening current account deficit is a negative. In India’s case however, it is almost acting as the counterweight to the hot money flows and is helping RBI avoid the nasty problem of either letting the currency appreciate (if it does not intervene by buying dollars) or increasing the money supply (it if does intervene). Contrary to a widely held belief, the hot money flows are not only equity markets driven. A good portion of this is also invested in debt in India and that is primarily driven by the differential in interest rates across developed economies and India. Since that is likely to last for a while owing to quantitative easing by the Fed, I would think the hot money flows are unlikely to abate in a significant way in the near future.
Structurally of course it is dangerous to have this fragile equilibrium for long. Hopefully some pick up in global economy would support exports growth from India and reduce the deficit. On the other hand, one can hope that the break up of the capital inflows moves towards more stable FDI. In fact, in one of the recent articles, The Economist highlights the so called 'Delhi Consesus' which in essence is about letting the capital inflows happen as a positive and much needed outcome of superior economic growth in emerging economies vis-a-vis developed ones. Following is an interesting graph from that article.
Even portfolio investments are made out to be much more volatile, bigger and potent villains than they really are. In a country like India sitting on over $280bn of forex reserves, a capital flight out of India of hot money can hardly bring about macroeconomic instability.
However, contrary to popular perception this need not cause the same degree of alarm it used to say 10 years ago.
In general a widening current account deficit is a negative. In India’s case however, it is almost acting as the counterweight to the hot money flows and is helping RBI avoid the nasty problem of either letting the currency appreciate (if it does not intervene by buying dollars) or increasing the money supply (it if does intervene). Contrary to a widely held belief, the hot money flows are not only equity markets driven. A good portion of this is also invested in debt in India and that is primarily driven by the differential in interest rates across developed economies and India. Since that is likely to last for a while owing to quantitative easing by the Fed, I would think the hot money flows are unlikely to abate in a significant way in the near future.
Structurally of course it is dangerous to have this fragile equilibrium for long. Hopefully some pick up in global economy would support exports growth from India and reduce the deficit. On the other hand, one can hope that the break up of the capital inflows moves towards more stable FDI. In fact, in one of the recent articles, The Economist highlights the so called 'Delhi Consesus' which in essence is about letting the capital inflows happen as a positive and much needed outcome of superior economic growth in emerging economies vis-a-vis developed ones. Following is an interesting graph from that article.
Even portfolio investments are made out to be much more volatile, bigger and potent villains than they really are. In a country like India sitting on over $280bn of forex reserves, a capital flight out of India of hot money can hardly bring about macroeconomic instability.
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