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Daniel Nestlerode: Correlation and Causation Regarding Investment Pricing

by on May 13, 2012 6:30 AM

Why do stock prices change?  The simplest explanation is that there is an imbalance between potential buyers and potential sellers which is ultimately resolved by changes in the price of the stock.

I suppose you could say this about anything that is bought or sold in a market economy where the buyers and sellers are free to set the price at which they will do a transaction.  It gets more complicated where rules, regulations and governments intrude into the market on the side of either the buyer or seller.

For example, the government is now intruding into the interest rate markets, setting the price for those who borrow historically low, albeit with many regulations attached and at the same time providing those with money to lend very low rates of return.

This is the Federal Reserve at work on their own agenda, which is not yours if you are a senior who saved or invested for retirement and now cannot earn a decent return on your capital.  But I digress, and as my coworkers will say, I digress a lot.

So the investment markets (both stocks and bonds) are constantly in a state of flux seeking points of stability where a transaction occurs.  The investment markets have many people buying and selling for a plethora of reasons, situations and circumstances.

People are involved in the business of investing for another plethora or reasons, situations and circumstances.  One of these circumstances is that if you have money beyond your current consumption needs or wants, then you are an investor, whether you thought you were or not.

It then follows that as an investor, where is your money invested and are you winning, or not?  People who have their excess money in cash are investors, they are holding non interesting bearing notes issued by the Federal Reserve which are either appreciating in value (during deflation) or depreciating in value (because of inflation).

Cash is an investment.

It has risk, in that it could be worth more or less tomorrow than it is today.  So, lots of people have investments for a plethora of reasons, situations or circumstances and they change their holdings from one form of investment to another for another plethora of reasons, situations or circumstances.

Figuring out the plethora of people who have investments and the plethora or reasons, situations and circumstances that lead them to change their holdings is a massive job, requiring lots of interactions with an analysis of everything going on in the markets, that state of flux looking for a momentary equilibrium point where transactions occur.

I haven’t gotten very far into the correlation and causation issues regarding investment pricing.  However, I believe my readers can now fathom that looking for the reasons, situations or circumstances for yesterday’s transactions is rather pointless in anticipating tomorrow’s transaction prices.

Everything we know today is insufficient to tell us the outcome of tomorrow.  And yet we try, again and again to find winning investments.  Some actually succeed, while others fail within specified time frames.  Investment is a very good game that most people cannot avoid.  The only choice you have is whether you are a winner or loser.

Games have rules and playing strategies and often end points or points at which we measure our progress against each other or against the returns of the market averages.  Many sports games are played for a set time.  Others are played until so many innings are completed or points are scored relative to the opposing player.

Investments are a continuous game played by professionals, amateurs, the competent, the incompetent, investors, speculators, insiders, outsiders and many others.  Yet we measure from time to time, the results of our efforts, or at least one should measure how you are doing from time to time.

In the endless search for the causes of the fluctuations in investment prices and momentary points of stability we are lost at best.  Ultimately we have no useful idea (a useful idea is one that can replicate the effect, so that you can know in advance if you are making a good investment) why stock prices fluctuate.

Still CNBC, IBD, Fox Business, the Wall Street Journal and Barron’s, Forbes, Business Week and the Economist provide endless fodder for those who graze at the table of reasons, circumstances or situations seeking a really good idea that will, hopefully, turn out well.  Even knowing yesterday’s actual causes of all transactions will not be very useful in determining tomorrow’s prices as darn near everything is in flux.

So investors usually ignore a lot of data and focus on the ones that make sense to them and place their bets.  We are not very good at multi-tasking we are good at ignoring things and arriving at erroneous conclusions.

Another wag pointed out that looking for causation is pointless as time is not linear, at least according to Einstein and others of his ilk.  If time is not linear that we cannot know if we have bumped into a cause or an effect or even if it is useful to distinguish causes and effects.

Lacking a good handle on causation, I recommend going for correlation.  Correlation is not the cause of anything but likens when two or more things show up together often or repeatedly.  Statistics has some distinctions about the coefficient of correlation measuring historically how often in the past that two or more things showed up together.

A coefficient of 1.0 means they always show up together and as you move to zero they never show up together.  Life generally occurs between something more than zero and less than one.  Value Line has done statistical studies of stock prices since 1965 and claims that corporate earnings changes are correlated to changes in stock prices in a positive fashion.

This means that if earnings rise, especially unexpectedly, the stock prices often rise also.  I suppose the opposite is true also.  Others such as William O’Neill have studied pricing patterns of transactions and because there is a certain repetition on some of these patterns, one can anticipate buying and selling points for stocks without having to search for the key set of causes.  He claims that his system works, although things often work until I try them and then something changes and they work less well.

Still, good statistical correlations are probably the best way to approach investments with the notion of winning.  Remember that all data used to anticipate future prices is based on history and as such past performance does not guarantee future returns with any degree of certainty.

You have to learn to invest with a degree of uncertainty always being present.   If you want guaranteed returns, be prepared to earn no return on your money.  Who would give you a guarantee and the lions’ share of the profits?  Certainly not an insurance company.  In their approach to investments, you get the false sense of comfort – a guarantee -  (supposedly low risk) while they get the profits and the fees.  The sales agents make out really well.  But I digress again.

I have made (and lost) a lot of money in my investment career.  Some came from the investment markets and some came from real estate.  Much came from keeping my expenses low and reinvesting constantly in my business and real estate.

All these things require time and attention, especially if they are going to work with any degree or reliability.  Still, after 47 years I don’t have a fail safe investment strategy that works every time.  I still have to pay attention and plow the profits back into the portfolio.

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Dan Nestlerode is the Director of Research and Portfolio Management at Nestlerode & Loy Investment Advisors in State College. A graduate of Penn State University, Nestlerode has been an investment advisor since 1965. He can be reached at danielj@nestlerode.com.
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