Gambler's Fallacy and the Stock Market: Mean-Reversion or Dilution

On an annual basis, the Dow Jones Industrial Average rose 66% of the time from 1896 to the present regardless of whether the market was up 20% the prior year, rose the prior year, or fell the prior year. (Marketwatch: Here are the odds that U.S. stocks will rise in 2016). From year to year, the stock market appears to follow a random walk. Over time, this random process dilutes the deviations from the long-run average. The Gambler's Fallacy basically says that if something happens more frequently than normal during a given period of time, it will happen less frequently in subsequent periods. Likewise, if something happens less frequently than normal during a given period of time, it will happen more frequently in subsequent periods. If stock market returns are completely random, then it would be false to believe that if the market was up one, two, three, etc. years in a row, the market would be due for a down year.

In contrast, the stock market's value may randomly wander around its intrinsic value. By reverting to the mean over time, the process is not entirely random. One could expect to take advantage of periods where valuations over or under shoot the mean. Models that attempt to take advantage of mean reversion such as Research Affiliates' Asset Class Expected Returns, GMO's 7-Year Asset Class Forecasts, and John Hussman's Market Cap/GVA typically use a time frame of 7-12 years.

Avoid the gambler's fallacy in the short-run, but keep in mind periods of overvaluation may lead to periods of under performance and vice versa. While there is no way to predict turning points based on valuation, it can used to manage risk, provide courage to buy when others are selling, and sell when others are waiting for one last rally.

Dollar General Carves Out Niche in Rural America

Capitalizing on the post-global financial crisis frugality theme, Dollar General is expanding in rural America by catering to low-income shoppers left behind by other retailers. As one of the most profitable retailers, Dollar General's stores are profitable with a footprint as small as a basketball court and fewer than 1,000 homes according to the WSJ interview with CEO Todd Vasos.

"Dollar General’s target shoppers come from households earning $40,000 or less. Its primary competitor, Dollar Tree Inc., has more suburban locations and sells all items for $1, including unbranded knickknacks that attract shoppers browsing for fun."

WSJ: Dollar General Is Rural America's Indispensable Store

“A forward earnings multiple of 19 times is the only thing about Dollar General that is pricey. It is justified by demographics alone.”

FT: Dollar General: buck stops here

About Dollar General

Dollar General Investor Relations

Form 10-K Risk Factors

Economic conditions and other economic factors may adversely affect our financial performance and other aspects of our business by negatively impacting our customers’ disposable income or discretionary spending, affecting our ability to plan and execute our strategic initiatives, increasing our costs of goods sold and selling, general and administrative expenses, and adversely affecting our sales or profitability. 

If we cannot open, relocate or remodel stores profitably and on schedule, our planned future growth will be impeded, which would adversely affect sales.

We face intense competition that could limit our growth opportunities and adversely impact our financial performance. 

Our profitability may be negatively affected by inventory shrinkage.

 Our cash flows from operations may be negatively affected if we are not successful in managing our inventory balances.

A significant disruption to our distribution network, to the capacity of our distribution centers or to the timely receipt of inventory could adversely impact sales or increase our transportation costs, which would decrease our profits.

Risks associated with or faced by our suppliers could adversely affect our financial performance.

Our private brands may not maintain broad market acceptance and may increase the risks we face.

 Product liability, product recall or other product safety claims could adversely affect our business, reputation and financial performance.

We are subject to governmental regulations, procedures and requirements. A significant change in, or noncompliance with, these regulations could have a material adverse effect on our financial performance.

 Litigation may adversely affect our business, results of operations and financial condition.

Our current insurance program may expose us to unexpected costs and negatively affect our financial performance.

 Natural disasters and unusual weather conditions (whether or not caused by climate change), pandemic outbreaks, terrorist acts, and global political events could disrupt business and result in lower sales and otherwise adversely affect our financial performance.

Any failure to maintain the security of information we hold relating to our customers, employees and vendors, whether as a result of cybersecurity attacks or otherwise, could expose us to litigation, government enforcement actions and costly response measures, and could materially disrupt our operations and harm our reputation and sales. 

Material damage or interruptions to our information systems as a result of external factors, staffing shortages or challenges or difficulties in maintaining or updating our existing technology or developing or implementing new technology could have a material adverse effect on our business or results of operations.

Failure to attract, train and retain qualified employees while controlling labor costs, as well as other labor issues, could adversely affect our financial performance.

Our success depends on our executive officers and other key personnel. If we lose key personnel or are unable to hire additional qualified personnel, our business may be harmed.

 Because our business is somewhat seasonal, with the highest volume of net sales during the fourth quarter, adverse events during the fourth quarter could materially affect our financial statements as a whole.

Deterioration in market conditions or changes in our credit profile could adversely affect our business operations and financial condition.

New accounting guidance or changes in the interpretation or application of existing accounting guidance could adversely affect our financial performance. 

Johnson & Johnson: Street Still Undervaluing Pipeline

After a banner year, $JNJ can keep rising https://t.co/QprG1dYcTy @JNJNews via @reshmakapadia #Remicade

— Barron's (@barronsonline) December 3, 2017

About Johnson & Johnson

Johnson & Johnson Investor Relations

Form 10-K Risk Factors

One of the Company’s key products, REMICADE ® (infliximab), is experiencing biosimilar competition, which will result in a reduction in U.S. sales of REMICADE ® .

Global sales in the Company’s pharmaceutical and medical devices segments may be negatively impacted by healthcare reforms and increasing pricing pressures.

The Company is subject to significant legal proceedings that can result in significant expenses, fines and reputational damage.

Product reliability, safety and effectiveness concerns can have significant negative impacts on sales and results of operations, lead to litigation and cause reputational damage.

Changes in tax laws or exposures to additional tax liabilities could negatively impact the Company’s operating results.

The Company may not be able to successfully secure and defend intellectual property rights essential to the Company’s businesses.

The Company’s businesses operate in highly competitive product markets and competitive pressures could adversely affect the Company’s earnings.

Significant challenges or delays in the Company’s innovation and development of new products, technologies and indications could have an adverse impact on the Company’s long-term success.

The Company faces increasing regulatory scrutiny which imposes significant compliance costs and exposes the Company to government investigations, legal actions and penalties.

The Company faces a variety of risks associated with conducting business internationally.

Interruptions and delays in manufacturing operations could adversely affect the Company’s business, sales and reputation.

An information security incident, including a cybersecurity breach, could have a negative impact to the Company’s business or reputation

Listen to Ed Thorp, the Man Who Beat the Dealer and the Markets

Listen to Ed Thorp, The Man Who Beat The Dealer and The Market from Masters in Business Podcasts.

 https://itunes.apple.com/us/podcast/masters-in-business/id730188152?mt=2&i=1000389899947

https://www.bloomberg.com/news/audio/2017-07-14/ed-thorp-the-man-who-beat-the-dealer-and-the-market

Using the Taylor Rule to Forecast the Federal Funds Rate

The Taylor rule is a formula devised by Stanford economist John Taylor. The formula was designed to provide a central bank with a guideline for determining the appropriate rate to set short-term interest rates.  The formula is:

r = p + 1/2(y) + 1/2(p-2) + 2

Where r is the federal funds rate, p is the inflation rate, and y is the GDP gap, which is the difference between actual and potential output. The 2 at the end is the historically neutral real federal funds rate. The formula assumes 2% is the targeted inflation rate. 


The federal funds rate is increased or decreased based on two variables: inflation and real GDP.  If real GDP rises 1 percent above potential GDP, then the federal funds rate should increase 1/2 percent. If inflation rises by 1 percent above its target of 2 percent, then the federal funds rate should increase by 1/2 percent. If the inflation rate is 2% and real GDP is equal to potential GDP, then the federal funds rate should be set to 4%. Research has shown the Taylor Rule does a reasonable job of estimating the federal funds rate (see chart here). Although, there have been a few attempts to modify the Taylor Rule of late. See  Bloomberg: Taylor Rule Change Will Hurt Fed's Inflation Fight, Glenn Rudebusch FRBSF Economic Letter , and John Hussman "Taylor" Your Fed Expectations for more on the Taylor Rule.
  
To solve for the current federal funds rate, one first determines the output gap. Current (2017 Q3) Real Potential Gross Domestic Product is $17,125.50 and the Real Gross Domestic Product is $17,169.73. The output gap is $44.23 or 0.2583% above potential. The inflation rate is 1.8% according to the latest year over year GDP implicit price deflator. The calculation results in a 3.83% federal funds rate.

The various forms of the Taylor Rule are provided by the Atlanta Fed's Taylor Rule Utility. The results for Q3 2017 are:

The Cleveland Fed Simple Monetary Rules page also calculates seven federal funds rates from various monetary policy rules, one of which is the 1993 version of the Taylor Rule.

The CME Fedwatch Tool can also be used to see what the market predicts the Fed will do at future meetings. There is currently about a 50/50 chance the Fed increases interest rates by 0.25% at the March 21, 2018 meeting.  

Companies that Burn Cash Have Low Probability of Long-Run Success

Five outliers - Chesapeake Energy, Netflix, Nextera Energy, Tesla and Uber - have collectively lost $100bn in the past decade. Shumpeter argues three elements are needed to skirt reality: a vision, fast growth, and financing.

Of the current members of the Russell 1000 index, since 1997 only 37 have lost $1bn or more for at least two years in a row. Of these, 21 still lose money.

Economist: Firms that burn up $1bn a year are sexy but statistically doomed

Form 10-K Risk Factors: Tracking Changes in Company Financial Reports

"Mr. Cohen and economists Christopher Malloy and Quoc Nguyen downloaded all the 10-K and 10-Q filings with the Securities and Exchange Commission from 1994 through 2014 and used textual-analysis software to create a similarity score showing how the language in corporate filings differed one period to the next.

They then looked at stock performance following filings. The finding: Shares of companies that had significant changes did much worse than those of companies that didn’t. This was particularly true when it came to changes in the risk factors section of 10-Ks."

WSJ: Hidden in Plain Sight: A Powerful Way to Beat the Market

Intel Reinvesting Free Cash Flow in Higher Growth Opportunities

"Yet even by 2020, Intel could generate $14 billion in yearly free cash, versus just $3 billion for Nvidia, judging by consensus estimates. That’s after research-and-development spending, which for Intel will top $10 billion this year, versus about $2 billion for Nvidia.

 Much of that cash comes from Intel’s mature PC business, and gets redeployed into higher-growth ventures like Mobileye; deep learning start-up Nervana, bought last year; Movidius, a maker of vision chips for drones, also acquired last year; and Altera, purchased two years ago, whose field programmable gate arrays, or FPGAs, can be used alongside Intel’s central processing units to speed up servers."

Barron's: Intel Finds New Growth in Artificial Intelligence

Company overview

Investor relations

Form 10-K Risk Factors

Changes in product demand can adversely affect our financial results.

• Demand for our products is variable and hard to predict.
• We face significant competition.
• Changes in the mix of products sold may harm our financial results

We operate globally and are subject to significant risks in many jurisdictions.

• Global or regional conditions may harm our financial results.
• We may be affected by fluctuations in currency exchange rates.
• Catastrophic events or geopolitical conditions could have a material adverse effect on our operations and financial results

We are vulnerable to product and manufacturing-related risks.

• Due to the variability in demand for our products and the complexity of our manufacturing operations, we may be unable to timely respond to fluctuations in demand.
•  We are subject to risks associated with the development and implementation of new manufacturing process technology
• We face supply chain risks
• We are subject to the risks of product defects, errata or other product issues.
• We are subject to risks associated with environmental laws and regulations.

We are subject to IP risks and risks associated with litigation and regulatory proceedings.

• We may be unable to enforce or protect our IP rights.
• Our licenses with other companies and participation in industry initiatives may allow competitors to use our patent rights.
• Third parties may assert claims based on IP rights against us or our products, which could harm our business.
• We rely on access to third-party IP, which may not be available to us on commercially reasonable terms or at all
• We are subject to the risks associated with litigation and regulatory proceedings.

We must attract, retain, and motivate key employees.

We are subject to cybersecurity and privacy risks.

• Third parties attempt to gain unauthorized access to our network, products, services, and infrastructure.
• We may be subject to theft, loss, or misuse of personal data about our employees, customers, or other third parties, which could increase our expenses, damage our reputation, or result in legal or regulatory proceedings.

We are subject to risks associated with transactions.

• We invest in companies for strategic reasons and may not realize a return on our investments
• Our acquisitions, divestitures, and other transactions could fail to achieve strategic objectives, disrupt our ongoing business, and harm our results of operations.

We are subject to sales-related risks.

• We face risks related to sales through distributors and other third parties.
• We face risks related to business transactions with U.S. government entities.

Our results of operations could vary as a result of the methods, estimates, and judgments that we use in applying accounting policies.

Changes in our effective tax rate may reduce our net income.

We may have fluctuations in the amount and frequency of our stock repurchases.

Workforce restructuring actions may be disruptive to our operations and adversely affect our financial results.

There are inherent limitations on the effectiveness of our controls.

No changes between 2015 and 2016

The Case Against GE - JP Morgan Analyst

"What I believe, whereas Mitsubishi Heavy Industries may come in with a gas turbine that’s a little more efficient than GE’s gas turbine and priced competitively, GE will come to the customer and say, “Hey, we will finance this for you at a very competitive rate, and make an investment in the power plant if you want us to, and throw in all this content.” And they do that at an all-in price that doesn’t necessarily position GE to withstand some of the risk that project may face over the next 18 to 24 months. Ultimately, where that will manifest itself, 18 or 24 months down the road, GE will book this charge that says, “Hey, we underestimated how much this would cost us.” But ultimately, they’ve already got the turbine in place. They’ve already got the market share. And that’s kind of the most important thing to them. That’s a big reason their cash flow has been so weak relative to their earnings."

Barron's: JPMorgan Analyst: The Case Against GE

Gabelli & Co Discuss Nordson

About Nordson

Investor relations

Form 10-K Risk Factors

Changes in United States or international economic conditions could adversely affect the profitability of any of our operations.

Significant movements in foreign currency exchange rates or change in monetary policy may harm our financial results. New risk 2015 annual report

If we fail to develop new products, or our customers do not accept the new products we develop, our revenue and profitability could be adversely impacted.

Our growth strategy includes acquisitions, and we may not be able to execute on our acquisition strategy or integrate acquisitions successfully.

Increased IT security threats and more sophisticated and targeted computer crime could pose a risk to our systems, networks, products, solutions and services.

If our intellectual property protection is inadequate, others may be able to use our technologies and tradenames and thereby reduce our ability to compete, which could have a material adverse effect on us, our financial condition and results of operations.

Our products could infringe on the intellectual property of others, which may cause us to engage in costly litigation and, if we are not successful, could cause us to pay substantial damages and prohibit us from selling our products.

Any impairment in the value of our intangible assets, including goodwill, would negatively affect our operating results and total capitalization.

We may be exposed to liabilities under the Foreign Corrupt Practices Act (FCPA), which could have a material adverse effect on our business.

Inability to access capital could impede growth or the repayment or refinancing of existing indebtedness.

Changes in interest rates could adversely affect us. 64% of debt floating rate.

Failure to retain our existing senior management team or the inability to attract and retain qualified personnel could hurt our business and inhibit our ability to operate and grow successfully.

The level of returns on pension plan assets and changes in the actuarial assumptions used could adversely affect us.

Regulations related to conflict-free minerals may result in additional expenses that could affect our financial condition and business operations.

Political conditions in foreign countries in which we operate could adversely affect us.

Our business and operating results may be adversely affected by natural disasters or other catastrophic events beyond our control.

The insurance that we maintain may not fully cover all potential exposures.

Liberty Media's John Malone Discusses Media and Cable Industry

CNBC’s November 2017 Interview with John Malone

Watch CNBC's full interview with Liberty Media's John Malone from CNBC.