The Glue that Binds

Information is the glue that binds. And it both builds and destroys portfolios.

Deep and poetic, huh?

Well, it's not my thinking, I took some literary liberty with a quote by author Tobsha Learner. I’m much more in the “Deep Thoughts by Jack Handy” camp, generally speaking.

But nonetheless, in the world of investing, information is absolutely the glue that binds. A financial market, at its core, is a simple information-discounting mechanism, where price is the messenger but not the message. In traditional finance theory, information is treated as a generic item.

This traditional approach implies that all types of information impact all investors equally, which is categorically incorrect. Financial markets are made up of different types of investors making decisions based on different time horizons. A given piece of information generally has varying impact depending on the time frame in which you are viewing the information.

So, information is not generic and it certainly does not impact all investors equally. Markets are liquid and stable, most of the time, because information is processed and valued differently across all time horizons.

If you buy in to my concept of information, then you can understand why I believe that as a trader, I’m nothing more than a processor of information. The better and more efficiently I process information, the better trader I will become and the better my risk-adjusted returns will become.

There are several key criteria to processing information more effectively.

First, is distillation. In this day and age, a large component of being able to better process information, is knowing what information not to pay attention to. You have to have a very fine filter on your information sources.

I’ve said it before but just from an economical data perspective, there may be 100 different data points that come out in a given week, of which, only 2-4 will actually impact asset prices for longer than 12 hours. You need to be a master distiller of information.

For instance, markets get all amped up for the monthly US ADP employment and non-farm payroll numbers. I’m not saying these reports aren’t important but the fact is that weekly unemployment claims report has historically provided a much more accurate picture of the US labor market.

I won’t geek out and bore you with talk about information ratios and the like, but statistically I can back up my perspective. I’m not trying to imply that you need to go out and back-test every economic indicator across the world to determine which are important and which are not.

It’s a matter of finding information sources that are consistent, objective and allow you to articulate a detailed perspective of the financial markets at a given point in time.

Second, be present. Stay with me, I’m not going to launch into a sermon about mindfulness.

If you focus your attention on better understanding what is happening right now, today, that makes you a contrarian and puts you on the opposite side of most market participants, which is a good thing.

Everyone and their mother is either looking in the rear view mirror and data from last month or last quarter, or they're trying to forecast earnings, S&P 500 prices, etc, 3 months in the future.

Processing information effectively is not about forecasting the weather for tomorrow but rather noticing that it is raining today.

The financial crisis is a case in point. Housing prices actually peaked in 2006, subprime indices peaked in January 2007 and money markets dried up in August 2007.

These events went largely unnoticed as the S&P 500 didn’t peak until the end of December 2007 and Lehman didn’t collapse for another 12 months. One of the ways I try to be more present, is by focusing on what is happening at the margin of economic data rather than the headline number.

For instance, last week June US retail sales were reported. The markets reacted negatively to the report because month over month sales decreased 0.3%, which was worse than expectations and a huge reversal from May’s 1.0% month over month change from April.

I’m not a big fan of month over month numbers because they are extremely noisy and prone to distortion. I’m also not a big fan of measuring anything against “expectations” because they are almost always wrong to start. Junk in, junk out.

However, I do like to view the year over year growth rates for specific data series and here again, specifically I like to look at the margin. June’s retail sales year over year growth rate was 1.4%, which was a decline from last month’s year over year growth rate of 2.3%.

This decline may not be an indication of anything to come. But there are two things I know for sure. First, the direction of year over year growth rates matter a whole lot more than month over month growth rates.

Second, I didn’t see 1 story on the retail sales number that highlighted this decline. In my own experience, focusing on whats happening at the margin of economic data sets, allows you to be more present than most market participants and that gives you an edge. The other way I try to be more present is by looking for more anecdotal information that helps me fill out the picture of what the world looks like at particular point in time.

All the better if that anecdotal information goes overlooked by everyone else. One example of this type of information is an interview I saw recently with billionaire Tilman Fertitta, chairman of Landry's Restaurants, which has a number of brands under its umbrella: Morton’s, Rainforest Cafe,  and McCormick & Schmick’s, just to name a few.

The reason this interview jumped out at me was that his perspective is based on running a global business that is involved in everything from real estate to labor and commodities. In addition, his perspective on inflation is very different from the prevailing talk of deflation.

“Well go buy something, whether at the grocery store, the drug store, the broom and mop store, and there is inflation everywhere.”I have so many types of businesses so I buy everything from labor, to mops, to food, to shrimp, to steak, and everything is more expensive. We're raising prices: that's why right now you pay more for an airline ticket, you pay more for a hotel room, you pay more for a pot of coffee. There is huge inflation going on right now.”

Now, I’m not saying that one quarterly report and one interview with a CEO are enough to warrant a complete change of strategy or an impetus to put certain trades on. But this type of anecdotal information, which flies in the face of what the crow believes and that is generally over looked by everyone else can provide you with a better picture of the present, and that clearer picture of the present gives you an edge over other market participants.

In decision making, uncorrelated inputs are more useful, but they take more cognitive work to process. We naturally tend towards information that confirms our biases for a particular market or economy. The real edge over other investors comes from being able to do the work that others are unwilling or incapable of doing.