Model Portfolio timbo56:SSOF1

The stock market is efficient, yet it is not. If we define efficiency as the use of publicly available information to set the price of stocks according to the most widely accepted information analysis methods, used by the biggest money players, it is indeed efficient. But that leaves a question: If the stock market is efficient, why do prices change so often by so much?? If we were to define efficiency as the use of publicly available information to accurately predict future returns, we would have to say that the accuracy is largely missing, or at least that the expectation of future returns varies dramatically from one year to the next. If we presume that the more recent estimates of future returns are more accurate than the older estimates, then something was wrong with those older estimates.So, why did the big money players, using the most widely accepted information analysis techniques come to incorrect conclusions regarding future returns?? To some degree, I am puzzled. It seemed obvious enough to me that the dotcom boom would bust, that U.S. machinery and steel stocks would rise and that Latin American markets would rise. Why wasn't it obvious to everyone?

I have a few theories. One is that even the big money players are vulnerable to a drive to conformity born of the greater error penalty accompanying unpopular choices. If 80% of the investment community believes that A is a great investment, then if manager 1 goes along with this point of view and invests in A and he is wrong, well, so was everyone else. He was just doing what all the other managers were doing. He never pretended to be a genius, just a pretty good money manager. But if he bets against A, against the other 80% and he is wrong, then he is an idiot. Everyone else saw that A was good, why didn't he?? At the time he placed his bet against A, it deprived him of credibility, just because it went against the norm. When A goes up, he is really "in the soup." He feels that 20 years later, when he is traveling incognito in New York, and he mentions that he has not been on this particular subway since 2008, the person next to him will say, "Oh, around here we call that the year of manager 1's huge mistake" and burst out laughing. So even the best and the brightest, shepherding the most money, are vulnerable to a tendency to defend their future reputations by adopting an investment strategy that does not differ "too much" from the most widely accepted contemporary viewpoint.

This drive to conformity, such a huge factor in human affairs, tends to warp stock values by making trends and biases more persistent than they would otherwise be. For example, it has taken the steel industry quite awhile to shake its terrible image from the 1990's and early 2000's, when Bethlehem Steel, among others, went broke. AK Steel (AKS) had a low in the 2's back in 2002, but now it is a little over 68. And I'll be darned if it isn't true that during that whole, hugely-profitable-for-some trek up, its mean analysts' rating never got better than a very, very bad 3. The bad image from the earlier years has stuck like glue that the domestic steel companies just cannot seem to shake off. Not to mind. The terrible image has kept the doors of opportunity open for those who don't mind taking a risk and going against the analysts' ratings. Back in 2005 I wrote a Marketscope piece recommending the domestic steel companies. Directly afterward, their stock values plunged. But all of my reasoning was long term, and now the prices are 3 to 5 times what they were before that plunge. It was difficult when I had gone against the accepted viewpoint and felt that I had lost. But I never lost the confidence of my vision. I kept the bet going and have won big since that time.

It is my basic point, although I know that I cannot prove it, that the drive to conformity lent persistence to the bad image of the steel industry. Each analyst was afraid of going against the negative consensus view. So that negative view persisted far beyond the time when it was reasonable. The truly sad effect is that portions of the domestic steel industry were sold to foreign entities during that time. I don't mean to sound like a narrow minded Chauvinist, but those were valuable assets that were sold to foreign entities at woefully low valuations. It is just very sad that no Americans (well moneyed enough to do it) saw that value and held onto it.