The Nobel Prize for Market Timing Goes to… Cliff?

October 22nd, 2013
in contributors

Money Morning Article of the Week

by Robert Hsu

According to the Efficient Market Hypothesis (EMH), the best - and perhaps only - way to outperform the market over time is simple:

First, claim that beating the market over time is virtually impossible. Then, take home $1.2 million for "proving" it.

That was Professor Eugene Fama's approach, anyway, after co-winning the Nobel Prize in economics.

Follow up:

Don't get me wrong. As a professional investor and portfolio manager, I believe Professor Fama's EMH has many valid ideas. But fundamentally, people like us (and Buffett, and Soros, and Rogers, and Lynch, and Einhorn, and Paulson, and Icahn, and Ackman) never swallow EMH whole.

Ironically, neither does Clifford Asness.

Why would one of Fama's brightest students decide to ditch EMH, and pick stocks and time the market instead?

Proving EMH "right" may be worth millions (to Fama). But proving it "wrong" is worth billions...

The First Step to Beating the Market

As you'll recall, the big news in finance academia last week was the awarding of the Nobel Prize in economics to University of Chicago professor Eugene Fama. The prestigious award was given to Fama for his work in so-called Efficient Market Hypothesis, or EMH. This is the concept that market participants rationally discount new information, nearly instantly, and that this makes it virtually impossible to "time the market" and/or outperform the broad stock market consistently over time.

We believe that the market is only partly efficient. That means you can time the market - and beat the market-if you know what to look for.

That was, in part, Cliff's conclusion, too...

Cliff was a colleague of mine at Goldman Sachs. And he was one of Professor Fama's brightest students and research assistants at the University of Chicago. While still a graduate student, he wrote a paper on the Efficient Market Hypothesis.

But, unlike Professor Fama, Cliff's research, done while writing the paper, brought him to the conclusion that it is, in fact, possible to outperform the market by a combination of superior stock picking and market timing.

And he was willing to put his money where his mouth was.

Cliff left academia and joined Goldman in its fast-growing hedge fund division. And he didn't disappoint.

He and his team consistently produced market-beating returns. In fact, Cliff was already a star at the company when I began working at Goldman's hedge fund division during the mid-1990s.

In 1998, Cliff left Goldman and launched his own hedge fund firm, AQR Capital Management, which continued to consistently outperform the market. Today, AQR is one of the most successful companies in the hedge fund industry, and Cliff has become a billionaire.

So, how did Cliff do it? How has he beaten the market - significantly - over time?

You Can Do It, Too...

The first step is to realize that markets are not always efficient.

One of the most obvious market inefficiencies is the fact that investors do not always behave rationally. This is especially true when the extremes of fear or greed dominate the market milieu.

For example, during times of panic dominated by fear, investors often engage in irrational selling. This is precisely what happened during Black Monday - the market crash of October 19, 1987 - when U.S. stocks sold off 23% without any meaningful change in market fundamentals.

Conversely, when greed dominates markets, investors often engage in irrational buying.

In 2000, during the height of the tech bubble, 3Com Corp. spun off its wholly owned Personal Digital Assistant (remember those?) division, Palm, via an IPO. Palm only accounted for 15% of 3Com's earnings at the time.

But, by the close of trading on its IPO date, Palm was worth nearly twice as much as 3Com - which still owned 95% of Palm - simply because Palm was in the white-hot telcotech sector.

These examples of irrational behavior are just two of many such decisions driven by extreme fear and extreme greed.

When the emotional pendulum swings toward either end of the fear and greed spectrum, when investors behave irrationally, is precisely when markets are inefficient.

The way to make money during these extreme times is to avoid getting caught up by the prevailing emotion, to act rationally, and go straight in the opposite direction.

Now that you know that market timing can be done, I'll return next week to tell you exactly how it's done. We'll look at details of how I personally time the markets, and exactly what we should be looking at to get the most accurate reading of market sentiments. And, most importantly, we'll look at some fantastic opportunities to test these new skills - and make a killing in the process.

In the meantime, here are some of the investable ideas we've looked at together over the last few weeks - all of which are worth considering at current levels...

These Income Stocks Are High Growth in Disguise
Classifying MLPs as "income" stocks is a big mistake. It's a costly one too...especially if it's growth you're after. Yes, the partnerships toss off tons of cash. The high-net-worth folks I work with can achieve, for example, $350,000 in cash payouts from investing $5 million in an MLP yielding 7%. But they're more like growth stocks in disguise...

A Safe "Specialty Fund" that Pays Up to $850 a Month
The long-term growth potential alone makes these shares worthwhile. But you'll also get a ton of cash - up to $850 a month, depending on how much you invest. That's what makes these "specialty funds" so special. They do the work, you get the money...

How to Give Yourself a 10% Pay Raise in 10 Minutes Flat
There's only one reliable way to make 10% or more a year... especially now, in a rising interest rate environment. Growth and income are inseparable. The three companies you'll see today are perfect examples of this. And "total return" has never been more important to seek. These shares will pay you 5% to 10% in cash.

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