If You Focus on Average, You Get Average

No, this week’s commentary isn’t going to be a Tony Robbins-esque speech about not settling for mediocrity. Rather, with so many new readers, it’s a good opportunity to discuss why I believe in focusing on slopes rather than averages. Most investors, media gurus and other market participants are consumed by averages.

The simple fact is that if you focus on average, you get average.

A true edge and subsequent ability to outperform other investors over long periods comes from focusing on the “slopes,” which is how fundamental and quantitative data changes as we move through time.

 

Fundamental Slopes

When a fundamental data point is released, the first thing most analysts and talking heads judge is how that number stacks up against expectations.

“Expectations” is just another word for consensus and a consensus is just an average of participant’s views. For example, the July report for US retail sales was reported last week. Retail sales grew 0.6% month-over-month from July. This compared to the consensus of 83 economists, or expectations, of a +0.4% month-over-month growth rate.

What does this tell us? It tells us that retail sales beat the expectations of 83 economists.

Does that give us an edge? How do we know if the economists’ numbers are reliable?

What you rarely hear is the range of the economists’ estimates. What you typically find for a data point like last week’s retail sales number, is a range of estimates from +0.1% all the way up to +1.2% growth.

Wouldn’t it be far more valuable to understand how one economist reached an estimate of +0.1% or why another one believes that retail sales would crush it and grow +1.2% month over month? Rather than the 81 other economists whose estimates ranged from +0.55% to +0.65%?

When it comes to economic data I’m far more interested in the slopes, which I define as the change in the annual growth rate of a data set from month-to-month.

The retail sales annual growth rate in July accelerated higher from June’s +3.4% pace to +4.2%. Now this provides us with some valuable information.

First, it tells us that retail sales are accelerating or improving.

Second, and more importantly, this acceleration broke a five-month streak of declining retail sales.

It's far more valuable, as an allocator of capital, to understand the context of a fundamental data point rather than whether that data point met, exceeded or missed the expectations of a room full of economists. Remember, if you focus on average, you get average.

 

Quantitative Slopes

Investors’ infatuation with averages is not just a phenomenon found in fundamental data, it’s also prevalent in the analysis of financial market quantitative data.

Not a day goes by that you don’t hear about this market trading above its 100-day moving average or that market crossing below its 50-day moving average.

The real question is: Do moving averages give you an edge? Do they tell you something valuable about a particular market? In a word, “no.”

Moving averages provide no useful edge for trading.

There is absolutely no data to suggest moving averages provide investors with a reliable prediction of future price movement. The only thing a moving average can do, is very quickly tell you what the trend of a particular market is over the particular time frame of the moving average.

But moving averages aren’t the only aspect of quantitative data investors misuse.

An index is nothing more than the average performance of all the index's components.

For instance, the average performance of the S&P 500 index since July 19, via it’s exchange-traded fund proxy, SPY, is -0.64%. The average daily volume has been 59MM shares and the average weekly volume over that time has been 262MM shares.

Does this information help you evaluate whether to allocate capital to SPY, or US equities in general? You know the daily and weekly volume and you know that SPY is essentially unchanged over the last month.

There is no edge in this average information.

This is not to say quantitative data of the SPY over the last 21 trading days can’t provide us with valuable insight, quite the opposite.

For instance, during those 21 trading days, SPY made brand new all-time highs on 4 separate occasions, which is equal to one every five days. Remember, “all-time” is a very long time indeed.

Not only that but SPY posted daily gains on 12 of the 21 trading days. However, the volume on those “green” days were 17% less than the volume on down days. This development in volume over the last month is in stark contrast to the first seven months of the year when volume was approximately the same on days with gains and days with losses.

We now have much more information to work with than what the averages alone provided.

That said, this information isn’t enough, by itself, to tell us how to trade SPY. But this more detailed analysis, driven by understanding slopes, paints a clearer picture of the US equity market than just evaluating averages alone.

 

Fitting In is Boring

Adam Levine once said, “Fitting in is boring for anyone that wants to be extraordinary.” Most investors are satisfied fitting in and using averages to drive their investment process. That’s why most investors have a very difficult time earning consistent, above-average returns through all types of market conditions.

You can gain far more insight into financial markets by understanding the slopes. What’s more, because most investors are solely focused on averages, those insights will allow you to see opportunities, and risks, that most investors miss.