P/Eing into the wind

During the market rally post-March '09, I remember seeing a hedge fund manager being interviewed on Bloomberg TV (don't worry, I don't make any actual decisions based of financial TV, but it's great for making you feel like things are really happening every day). He was talking up his book and the fact that he was short the S&P until it hit 600 because throughout history great bear markets had bottomed when the P/E ratio had hit 5.




Now, this chap may have: stuck to his guns and spunked a great deal of his clients' money, but no doubt continues to be trusted to do his job because as we all know, if you're right you're skilled and if you're wrong you're unlucky or; hopefully realised what a complete and utter cretin he was and closed his position and quit the markets forever.



Why on earth would anyone, who I assume has some basic understanding of markets, make such a dumb, dumb, DUMB bet? And before you ask, of course I was long....



There are two big problems here. The first is to do with causality.



Do you think that some kind of irresistible magnet drags markets down until P/E hits 5? Do you really think that it is that easy to make money from the market? A brick wall will stop my car every time I drive into it but thankfully it is not inevitable that the wall will attract my car every time I drive past.



The second is more common and more inexcusable. It is a basic finance issue that nobody seems to pay any attention to. I apologise for shouting but P/E IS A FUNCTION OF INTEREST RATES!



The required return on equities is the risk-free rate plus a risk premium. As interest rates fall, the required return falls and P/E rises. Now let's see if you can piece this complicated puzzle together: interest rates are at record lows....lower interest rates mean higher P/Es....so....maybe P/Es now are likely to be higher than in the past? Well done, you are smarter than a hedge fund manager. But poorer.



I can't remember who said "investing is simple but difficult", but it is. Buy cheap companies and sell them when they're not cheap. The difficult part is explaining to your clients/wife/self why they sometimes get cheaper and cheaper and cheaper (BP was cheap at £4.50 and £4, wasn't it?)



Trading, especially with leverage, is not simple or easy because "the market can stay rational longer than you can stay solvent" (that one was Keynes). In the short and even medium term, markets can do pretty much anything and you HAVE to take account of sentiment, liquidity and a million other variables. So when you see someone tell you that the market is going to go to X price at Y time due to some basic indicator throw whatever comes to hand at the television. And if they manage your money, fire them!