Taking The Red Pill: All Fundamental Data Is Wrong

All fundamental data is wrong in some way. Some of it is incorrect, some of it is published by people with a vested interest, and some of it is lies. I am not angry about it, but I think we should face the sometimes harsh reality provided by the Red Pill.

Let us start with company-provided information. If the history of public corporations tells you anything, it is that anything a corporation tells you should be treated as a lie. Sometimes it is deliberately misleading, sometimes it obscures the truth, and sometimes it just lies to your face. If you do not believe me, then I point you to some of those who were caught: Enron and Lehman Bros stick in the mind, but the list is long.

Do not kid yourself that these are the rogues in an otherwise healthy bunch: every public corporation twists and tortures their information to meet their objectives. In a previous life I was a company auditor, and I can attest that there is plenty of scope for maneuver within the law. In a Barron’s interview, forensic accountant Howard Schilit put it like this:

Here is how the auditors look at the world: They think of themselves and their legal liability issues first; if it’s in the rule book and disclosed, you are covered. Second, they think of their clients. The client asked them to do something, and they want to please the client. A very distant third is they may occasionally ask: How does this look from the perspective of the investor? Investors would be astounded if they realized that this is how the party that is supposed to protect them views the world.

Similarly, the New York Times reported on an investigation by the Public Company Accounting Oversight Board that reviewed multiple audits performed by ten different auditing firms. All of those firms were reported to have performed audits that were unsatisfactory and flawed.

Some data is clearly to be more trusted than others: anything a CEO tells you is not even worth a pinch of salt, whereas tax returns are probably more reliable (not because no-one ever lies on their tax return, but because the consequences of doing so are reasonably high, and there is at least a chance of being prosecuted). But the evidence is overwhelming that company executives have a vested interest in portraying as positive an image of their company as they can, and that they can and do lean on all sorts of levers to manipulate the data they present to you.

Trusting the data a company gives you is like believing what Saudi Arabia tells you about their oil reserves, or what North Korea tells you about their nuclear weapons: it might be in the ballpark of True, but it undeniably comes from someone with a vested interest in the outcome. Company data also carries the material risk of missing information: what they tell you might be true, but what they choose not to tell you is important as well.

It is difficult to believe data released by government organizations either. The US Government and the Federal Reserve have a vested interest in persuading you that unemployment and inflation are lower than they actually are. They might not be deliberately falsifying the figures a la Argentina, but there are more subtle institutional pressures to chose assumptions and methodologies than systematically underestimate certain measures.

Just as pertinent are the revisions. Fundamental data is often revised. Corporations restate their earnings. GDP and employment figures are adjusted materially months later. If data can be revised long after the fact, it makes little sense to base investment decisions on the originally announced variable.

Every computer programmer knows that if you input garbage, you output garage. Doing analysis based on discounted cash flows, or price/earnings multiples or supply/demand components is all well and good, but if you cannot trust the data, you cannot trust the output it produces.

I am not one of the Black Helicopter crowd that sees conspiracies at every turn. I believe that Armstrong walked on the moon, that Oswald shot Kennedy and that earthquakes are generally caused by shifting tectonic plates rather than the CIA*. My skepticism regarding fundamental data does not come from a dark and bitter place, but rather from a frank and honest acknowledgement that data is prepared and released by people and that people tend to act in their own self-interest. Even honest, well-intentioned people are humans, and humans are susceptible to spinning bad news as good and lying by omission.

I use fundamental analysis every day. It can be an important part of the trading process. However, I treat all fundamental data with a strong pinch of cynicism, a healthy sense of skepticism and a highly-refined BS Detector. When placing my own money at risk, I think it is better to see the world as it is, rather than how I might want it to be.

* I think that people are attracted to conspiracy theories because they find comfort and security in the  notion that someone is in charge, rather than accepting that most things happen due to random chance.

The Fundamentals Do Not Matter As Much As You Think

A large amount of time, money and effort is spent by traders, investors and analysts examining “fundamental data”: company balance sheets, market reports, news items, supply and demand analysis. Blogs, books, newspapers and analyst reports are filled with analysis of fundamental information.

For example, the extensive blogroll on FT Alphaville currently links to 89 blogs; my rapidly unscientific survey identified that about 86 of those deal with fundamental information, and one appears to specialise in pictures of bank CEOs looking like Austin Powers. Traders and investors spend an extraordinary amount of resources investigating and analyzing the fundamentals, looking for clues about how to place their risk capital to work.

The good news is that the fundamentals do not matter. Or at least, they do not matter as much as people think they do.

Most people seem to believe that if they do their research properly, if they are more thorough and diligent than that other guy, if they have just one more piece of precious information, then they will know what to do. And then they will make their fortune.

They are wrong. The fundamentals are a tool. At best, they are an important but minor piece of the puzzle of extracting positive risk-adjusted returns. At worst, they can be highly misleading and distracting.

It is crucial to realize that traders do not get paid for predicting the fundamentals. We get paid for making money. And making money is far more about managing risk than it is about guessing how fundamental data is going to change. As Michael Covel puts it:

“Trading is trading, and the name of the game is to make money, not get an A in “How to Read a Balance Sheet.”

Look at it this way: imagine I am like Biff in Back To The Future II, and I have a Magic Almanac from the future. Imagine that I tell you exactly what the US unemployment rate, the GDP level, the amount of crude oil in storage and the balance sheets of the top 10 largest public companies will look like in 12 months time. That would be pretty helpful, wouldn’t it? You could make some pretty good money of that, couldn’t you?

While that information would be a useful tool, there are several problems in turning that perfect knowledge into cash dollars. Even assuming that my Magic Almanac is correct, you will not know the most important things that will determine if you make money or not. Primarily, you do not know how the market is going to value a certain level of unemployment, or crude oil inventory or even a given balance sheet in the future.

Just as bad, even if you are pretty confident that the market is going from point A (today) to point D (in a year), you do not know the path the market is going to take to get there i.e. where are points B and C along the way? Without knowing that you could be taken out of your position before you get there, either by a margin call or by your own flawed and emotional brain*.

Fundamental analysis does not give answers to the vital questions of how to enter a market, what market to enter, with what position size, and when to exit. The answers to those questions are given by a traders’ risk management system. As Peter Brandt puts it,

“Analysts are paid by being right… Traders are paid by managing risk. These two skill sets are a world apart.”

Most successful traders do understand the fundamentals of their markets, but it is only a small piece of the puzzle of extracting positive risk-adjusted returns.

* No offense intended. You should know that your brain is flawed and emotional. So is mine. It is because we are descended from monkeys.