The Rules Haven’t Changed


Originally published on October 16th, 2017 by Tony DiGiovanni via LinkedIn.

The third quarter is in the books and not much has changed from the first two quarters. To summarize:

  • The market continues to rise in a slow and steady manner with very few pullbacks.
  • Interest rates and inflation remain subdued.
  • International markets rising faster than US markets.
  • Investors continue to pour into passive index funds pushing the FANG+ stocks higher (though not all participated in the 3rd quarter).
  • While pricey, the market is not in a bubble. In other words, a major 30% correction or more is not in our forecast. Still, because of the very low volatile environment, a 10% correction will feel painful. That could happen at any time, but we can’t predict when.

The index theme is an interesting phenomenon, and one worth watching. Theoretically, if everyone invested using a market price based index (which is how the S&P 500, representing the largest 500 companies in the US, and the Russell 3000, representing all companies in the US, are constructed), then the markets themselves would be terribly inefficient. Our economy depends on price signals. The companies that do well and whose stock price rises draws competition into their sector. If all stocks moved only based on how big they are, then it wouldn’t matter how well a company was doing and that price signal would be lost. While 100% indexing will never happen, it is safe to say the market becomes less efficient as more investors use passive investments.

Counter to this trend is the increasing use of artificial intelligence (AI). AI is essentially a computer algorithm that can learn and perceive things much in the way a human does. This technology is in its infancy, and so still cannot compete with the human mind in general. Still, there are some very specific AIs that have surpassed human capability. IBM’s Deep Blue computer (precursor to Watson) famously beat Garry Kasparov in a chess match 18 years ago and has only gotten smarter. One could argue that no human will ever beat Deep Blue again.

In the investment world, investment firms are increasingly using the combination of big data and artificial intelligence to make investment decisions. The amount of data available has exploded beyond what any one person could possibly analyze and comprehend. Most of us have a hard enough time just keeping up with email. So, getting a computer to analyze the floodgate of information has become increasingly important.

Recently, at a CFA (Chartered Financial Analyst) Society of Detroit meeting, speaker Michael Bishopp described how his firm, BlackRock, is using AI and Big Data. His firm uses satellite images to capture daily trucking activity on the ground. From those images and maps of company facilities, a computer can comb through the data and make inferences as to which companies have more activity over a set period of time. Couple that with data on how the company’s stock is doing relative to current fundamentals, and the AI can come up with a portfolio of stocks poised to do well.

This is a fascinating and creative use of AI and Big Data. That is a lot of firepower analyzing all available information to try to gain a competitive edge in the marketplace. Theoretically, however, this is no different than what analysts have been doing since the stock market’s creation. All that will happen with this new technology is that the market will become ever more efficient. A market is considered efficient when a company’s stock price is a true representation of the company’s intrinsic value given all of the data available. With computers getting better and better at analyzing all available data, it won’t take long to get to a theoretically efficient point. All available data properly and expertly analyzed will only help with short term pricing. In the long-run, companies that earn their cost of capital will still be good investments while companies that don’t, won’t be. As an aside, passive investing using index funds is a very simplistic form of AI. It uses one variable to construct a portfolio – company size. This strategy’s days are numbered.

With the rise of ever smarter computers, it is interesting to note that the key strategies to be a successful investor will not change. Our job at White Pine will still be to construct a portfolio plan that will help our clients achieve their long-term financial goals. This will still require time to learn what our client’s goals and dreams are and how willing they are to take on risk to achieve them. Striking the right balance of stocks, bonds, cash, and other asset classes to optimize the trade-off between risk and reward will continue to be critical. With the right balance, our clients will withstand the inevitable pullbacks in the market to put them in a position to benefit from the also inevitable periods of growth and prosperity. The details and specific strategies within the portfolio may change as AI develops, but the basic sound investment principals will remain the same: Make a plan and stick to it. Happy investing.

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