Perspectives for Natural Resources Investors: Another Yarn from Oz…

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The Efficient Markets Hypothesis, Molecules of Mayhem and Market Instability! 

At MiningMaven we leave no stone unturned in our quest to give ourselves, and investors who follow us, an edge over the herd. By focussing our investments in the natural resources sector we expose ourselves to the most volatile and high risk sector of the stock market.

It’s a fact that the majority of natural resources companies will ultimately fail, and so too will the majority of those who invest within them. But some companies will succeed, and in spectacular proportions, and so too will many of those who invest within them.

So is it really possible to beat the market, and with consistency? The Efficient Markets Hypothesis suggests that our fate over time is to break even at best. With transaction costs foregone, along with bank interest on our cash, then add in the effects of inflation; this ‘breaking even’ over time will likely as not amount to significant losses.

The Efficient Markets Hypothesis: Can Neuroscience Subvert it?

This hypothesis states that when information arises in markets, it spreads rapidly and is quickly integrated into share prices. Trying to beat the market it says, is a fool’s errand because if the information is out there, it’s already priced in. And that a trader or investor who attempts to buy low and sell high, will over time, always return to break-even. It further suggests that no amount of fundamental or technical analysis would enable an investor to achieve greater returns than randomly selecting a portfolio of similar risk. And it sees stock prices as taking ‘random walks’ along charts, direction unknown.

In 1978 US economist Michael Jensen declared, “There is no other proposition in economics which has more solid empirical evidence supporting it, than the EMH.” Such bold statements tended to elevate this hypothesis almost into general acceptance, and created an impetus for the establishment and growth of managed funds. But Arthur M Okun Professor of Economics at Yale University, Robert J Shiller, sees the EMH very differently. Amongst Bloomberg’s 2011, ‘Fifty Most Influential People in Global Finance’, Shiller takes an opposite view to Jensen, describing the EMH as “The most remarkable error in the history of economic thought.”

Intellectual dominance of the EMH is more recently being challenged by those economists who stress the importance of psychological and behavioural elements in stock price determination. Shiller’s book ‘Animal Spirits: How Human Psychology Drives the Economy and Why it Matters for Global Capitalism’ says economists have de-emphasised the importance of emotional factors because they are difficult to model and quantify, and inconveniently, elude containment within mathematical formulae. As dedicated natural resource stock investors, it would seem that by default, we are not proponents of EMH and therefore we believe we can not only match the market indices but outperform them, and with a reasonable degree of consistency.

The question is how do we do this? Successful investors know there is no substitute for research across specific stocks and the multitude of factors which can impact them, for better, or for worse. But as Shiller points out, human emotion and its consequence is an additional key factor in the determination of investment outcomes. As human beings we are emotionally driven. We feel good when our investments serve us well and bad when it they don’t. Such feelings may even be stretched to euphoria or despair, depending on our degree of success, or otherwise. But in order to minimise the impacts of emotionally driven investment decisions, it helps to understand the neurological effects of both testosterone and cortisol, which left unchecked, can potentially decimate our strategies, and ultimately our portfolios.

Testosterone and Cortisol - The Good, the Bad and the Ugly

The seemingly disparate connect between neuroscience and finance is further bridged by neuroscientist, economist, former Wall Street trader, and University of Cambridge research fellow, John Coates. His published work looks at the effects of testosterone and cortisol in male traders; but research into the different styles of risk taking between males and females, and the effects of hormones thereon, is also a current focus of his. Although Coates focussed his research on Traders; by its very nature, the dynamics of the natural resources sector can and will also throw up similar high stress dealings for investors therein.

Known as the male sex hormone, testosterone is said to be what makes a man a man. It should be noted however that women also produce and utilise this hormone, albeit in lesser amounts. As well as the physical attributes this hormone bestows on men, it is also a key driver of non-physical elements such as confidence, assertiveness, optimism and increased risk propensity. Testosterone levels peak at around age 20 and from the early 30’s steadily decline, with many men in their 50’s and 60’s having levels below what is considered desirable. Declining levels with age often results in a fading of self-confidence, optimism and risk appetite.

Cortisol, commonly referred to as the stress hormone, prepares the body for perceived danger, in part by increasing alertness and by enhancing the ability to retrieve important positive memories. For an investor facing perceived threat these cortisol effects are a positive. But over a longer period, as in a sharp and prolonged market downturn, chronically high cortisol levels impair the ability to think rationally, causing the mind to linger on negative memories and to perceive threats that don’t exist. Coates research showed traders operating under such conditions were not aware of the stress they were experiencing even though their cortisol levels were sky high. Coates suggests women are less likely to experience excessive euphoria after a winning streak (my wife excluded of course!), due to them being less affected by the hormonal stress responses evoked in men.

In his book ‘The Hour between Dog and Wolf: Risk Taking, Gut Feelings, and the Biology of Boom and Bust” Coates describes how the market cycle is driven by irrational exuberance at its peaks, and irrational pessimism in its troughs and suggests these overshoots are hormonally driven. He says the holy grail of economics is to find out where financial instability actually comes from, and suggests economists haven’t done that yet because they’ve largely ignored the role of human emotion in economic decision making.

Justin Fox is editorial director of the Harvard Business Review and a business and economics columnist for Time magazine. In his book “The Myth of the Rational Market’ Fox suggests the upside of the Global Recession, is that it could drive a stake through the heart of the academic nostrum known as the efficient markets hypothesis. He argues that financial man far from being the perfect mechanical trader, generally follows the crowd, fails to plan ahead and often makes mistakes.

As Natural Resource Stock Investors, What Can We Learn From This?

The application of neuroscience to trader and investor behaviour and stock price determination is still in its infancy. As yet there are no defined strategies for dealing with hormonally induced emotional financial irrationality. At MiningMaven we thought the following points might help steer readers towards some of our own.

• The Efficient Market Hypothesis is just that, a hypothesis. But it’s one which is widely accepted and in some quarters, almost as law. The work of John Coates and others however, points to a more profound human element in stock price determination, and one driven to an extent, by hormonally induced irrationality. If we can be rational whilst others around us are not, then we have an edge over the herd.
• By simply being aware of the potential for our emotions to lead us to irrational transactions, we can step aside, watch our thoughts, and attempt to deal with a perceived threat in a logical manner.
• By constantly updating a rational strategy to deal with unexpected market movements before the event, we can follow a sensible strategy and not risk applying actions thought up on the run, and under pressure.
• Understand that in the heat of the moment, strict discipline is needed to follow through on a rational, pre-prepared strategy. Headlines such as ‘Fear as Stock Market ….……’ are always good testers of discipline. Rather than hit the sell button, a very good buying opportunity could have just commenced.
• Pay attention to ‘gut-feelings’. This inner voice is important as it is represents what many very successful investors call a ‘distillation of experience’. If a proposed investment decision looks good but just doesn’t feel right, it probably isn’t.
• Fundamentals relating to natural resources stocks are dynamic in nature and whilst your own quality research is critical, it’s only as good as it is current. Don’t let market gyrations undermine investments made on the basis of sound and up to date research.

Following my maiden MiningMaven blog post, Swimming with Sharks, I now find myself nursing a broken limb after running into a cyclist. Not in the car thank goodness, but literally running into it whilst pursuing my latest get fit campaign gone wrong. It just goes to show that nothing worthwhile is ever without risk, and that market cycles are not the only ones we need to keep an eye on! And if you’re planning on running to get fit, maybe do it on a treadmill!

Regards

Kevin Jones

Director of Australian Operations

MiningMaven