Confidence Isn't Everything

Dr. John Brush of Columbine Capital, a mathematician by training, has dedicated mostl of his long career in financial research to the study of price momentum. Though he publishes for parochial gain rather altruistic enlightenment, this doesn't devalue his work. In his topical Twenty-Year Retrospective on Momentum made public in 2003, he stated categorically that contrary to his findings in other developed markets, Japanese (along with Scandinavian) markets exhibit strong properties of intermediate-term REVERSION, and NOT Momentum. This means the higher the historical relative return has been, the LOWER the forward relative return has been over the most fertile of intermediate-term momentum horizons (which is 12-months). To put it even more succintly: For the portfolio manager in Japan, buying what's "gone up" vs. selling what's "gone down" has been, over the last 30 years, one of the quickest routes to unemployment, not to mention penury.

This is most curious, since virtually all esteemed academic research indicates the opposite has been true in the rest of the world. Which is why hackneyed (but apparently true, on average) "old saws" exist like "Cut your losers & let your winners ride", or "Don't catch the falling knife". While they clearly have logic flaws if you examine their premises in greater detail, they are, like most demagoguery, based upon kernels of truth. So is Japan "different", and if so why? While it is true that collectively, the Japanese people believe themselves unique in many ways (their rice is supposed to be "purer", their beef is less contaminated, western medicines don't work as well as upon them, their snow is suublimely different so that European skis don't work as well in the mountains near Nagano, etc.), I would suggest they (the Japanese) have no monopoly on this belief since most cultures like to perpetuate myths about THEIR Tribe's superiority. But why on earth would or should Japanese financial markets be seemingly governed by different natural laws than our own markets?

For years I've meditated upon precisely this question, to the detriment of my golf swing and my love-life. To be sure, many plausible-sounding explanations have come and gone. Some have even survived the test of time (particularly those that cannot be easily measured). Here is my current (and most plausible) version: Since in the "longer run" stock price generally follows earnings, it's reasonably determinstic that continued price persistence of a security requires above-average growth in earnings (or long-run below-average earnings in most other stocks, though this route to relative momentum would, in fact, be bounded). Such positive earnings growth requires growth in sales and/or profit margins (though alone, the latter, too, would theoretically be bounded). So if reversion was to be considered the rule, rather than the exception in Japan, then growth must be bounded OR/AND the market's prices must be wrong (or a little of each). And they must be wrong enough such that when buying the portfolio formed upon prior high returns whilst selling the portfolio formed upon low measured prior returns, one not only doesn't make any money in the next period, but one loses it in buckets. This would tend to be indicative that too much return or discounting must have occured in the prior interval in the one or the other or both of the respective high and low return portfolios. In Japan, one has been rewarded for catching the proberbial knife, and penalized for being greedy and riding your winners.

But again, one might ask "why"? In reply, the arguments for bounded growth are seductive and numerous if not compelling. First there is GEOGRAPHY: Japan is an island and not a terribly large one. For those who received only passing grades in their georgraphy studies, it's located smack in between the Korean peninsula and China - both of whose peoples speak different if not mostly unintelligible languages and both of whom, more importantly, thoroughly detest the Japanese. This is not fertile growth territory for the convenience store chain wishing to to expand across the Sea of Japan. Second is DEMOGRAPHICS: Fertility rates in Japan are extremely low (and still dropping), and the population is aging rapidly. This is good for adult-use diapers, but less good for the unit sales of manga, toothpaste, or home furnishings. And they are a thrifty people, by necessity and nature. They are, by many accounts, also quite xenophobic too and outside of what they need for their immediate labour requirements (lapdancers, leather-workers, bargirls, TEOFL teachers, etc.), there is basically no immigration nor refugee uptake. Third, there is CULTURE: Japanese people speak errr ... umm ... Japanese. No one else in the world speaks (nor desires to speak) Japanese. This is both insulating and limiting. Microsoft did not arise in Japan possibly because Bill Gates was American, but more probably because the marriage of the Japanese language and the computer is a wholly unnatural act, sort of like asking a Snowy Egret to mate with a Belon oyster. Their culture also elevates the collective at the expense of the individual, and historically has fostered large oligopolistic behemoths at the center, with small depedent suppliers on the periphery. Together, this has been stultifying to entrepreneurship, limiting emergent growth to a handful of inconoclasts. Finally there is HISTORY: Japan's overseas "pecadilloes" (note: this is the polite term) during the first half of the twentieth century made them rather unpopular (note: also the polite term) with their immediate neighbors as well as with the rest of Asia (not to mention the people of Hawaii). Despite ideological differences, even Ho Chi Minh was more than happy to look to Uncle Sam for help to rid them of the Japanese occupiers. So deep and intense has this hatred been that the Chinese, from time-to-time, still feel it cathartic to do the old "smash-'n-'grabs" at anything visibly Japanese resting upon Chinese soil. Yet Japan HAS grown dramatically. The Japanese ARE world-class engineers, manufacturers, and scientists with an eye to detail and an unusual and mostly pleasant aesthetic, not to mention a strong work ethic. These ingredients have combined to form the basis for some of the World's largest and most fabulously successful firms that are champions in their industries. They have grown to an immense size, but done so relatively quickly. But this size, once obtained, itself constrains the size of future growth rates. And then there are the rest of the firms which have historically been constrained the limitations listed above. Finally, the biggest ones were also defined by, but limited by the consensual nature of Japanese society, and the brand of capitalism that was forged in post-war Japan which was one where shareholders are but one of many constituents (but which also include management, employees, suppliers, community, and cusomters). This has limited earnings growth at the expense of what western academics might term "empire building" - something that benefitted shareholders less than it conferred benefits upon the other constituents, including Japan Inc. collectively.

Clearly the price has been wrong (since, ex-post, they HAVE been excessive in the prior period) on sufficient numbers of securities or else reversion would NOT be pervasive. If, on the other hand, price had erred on the side of cautiousness in the prior formation period, then it would follow that price would continue in the same direction in the next interval. In this situation, if one was looking backward after holding the high and low portfolios for 12-months (with full knowledge of future returns) one would likely describe the Share Price as having "underreacted" to their prospects in the prior frame.

But "WHY" was the price wrong? Were investors historically just always over-reacting whatever they did - extrapolating trends forward that were not recurring and undertaking myopic loss aversion whenever a speed bump or earnings miss was encountered? I had always thought that the Prices were wrong in hindsight because the constraints upon growth (detailed above) led to two direct effects. First, the lack of growth meant that whenever the price of a share appreciated in the absence of growth, it was unlikely to be justified. The second was that the paucity of real and persistent growth opportunities across listed companies made such enterprises so scarce that their prices inevitably were bid up to levels above and beyond the associated levels of growth. So much so, that their future relative share-price performance were victims of their success, such that it was well-nigh impossible to keep up with expectations. And so the puzzle, having been explained, was kept in its box and trotted out ocassionally to VIPs when asked to explain why things were the way they were.

Then Kahneman & Tversky won the Nobel prize and behavioural finance exploded. Some alternative explanations appeared, and quite compelling ones at that. Academic researchers still do not agree on what precisely causes momentum. Some deny it exists altogether and claim it is a yet to-be-discovered risk factor. Others claim it is aliasing other things (future earnings & growth or changes thereof) and that while not explicable by CAPM, it IS rational. And there is some proof that this is true at least in part. Still others say that while it exists, it's loopy, looney, irrational and is firmly rooted in behavioural causes such as self-attribution bias or myopic loss aversion. These accounts say, that while it exists in the USA, it may plausibly be explained by "overconfidence" and "self-attribution biases". Tamura (2003) turned this on its head and suggested that "Reversion" is the rule in Japan because, citing behavioural psychologists Kitayama, Takagi & Matsumoto (1995), Japanese people seem to be guilty of little self-attribution bias. This is highlighted in the paper by the fact that when they succeed in something, the Japanese will ascribe it to external factors (e.g. "the simplicity of the task" or "luck"), rather than their own ability. Moreover, when they fail at something, they tend to blame it on personal factors such as the lack of ability, poor training or insufficent effort. So rather than being over-confident (which Daniel Hirschleifer & Subrahmanyam posited maybe be prerequisite for self-attribution bias and thus explaining the continuation effect), the Japanese are more critical, self-effacing, self-deprecating.

What is interesting is that Japan is now in the throes of a rip-snorting momentum craze. It is fast becoming a momentum market, resembling the other large western markets of the world. And the emergence of this momentum has coincided with a rise in the percentage of foreign ownership of the Japanese market, but more significantly, from the even larger increase in the percentage of turnover accounted for by "foreign" investors in general, and hedge fund investors in particular. Perhpas one could discount this as the inevitable trend towards "globalization". But while there is an element of truth in this, it is not the whole story since there remains stark cultural contrasts between Japanese investors and the foreign capital now calling the TSE its playground. The traditonal "bounds to growth" arguments remain plausible in some respects, but they too may be ebbing with time as a new generation whose hatred of things Nippon fades in intensity, and global fund managers blur the national distinctions and domicile of manager and funds managed.

For my view, I continue to pay quiet respect to the Momentum Gods, whose power carries with it the ability to cause large mark-to-market losses, and thus undesired margin calls, not to mention the transmission of material non-public information. But I remain suspicious of the longevity of these Idol's power, particularly where less-than substantiated by evolving objective fundamental changes, and where induced by the parochial greed and cynical disregard for fidcuiary resposnibility by agent fund managers with assymetrical incentives or motivations.