Jeff Schwarte was in a quandary. The manager of the $3.5 billion Principal Large Cap Value Fund had held a big stake in Apple stock since 2004. Eight years later, in mid-2012, his analysts remained bullish on the stock. But since the start of the year, the algorithms in Schwarte's quantitative valuation models had warned that Apple's profit margins were shrinking.
As Schwarte weighed the evidence, he got an e-mail about his Apple stake from behavioral finance consulting firm Cabot Research. It was an automated alert about positions that Cabot -- which Principal Funds had hired to analyze manager portfolio holdings and trades for behavioral flaws -- sends about positions that might indicate a bias. In this case, Schwarte said, his analysts had fallen victim to "the endowment effect": Someone with a winning position is reluctant to let it go even if there are good reasons to do so.
So he trimmed his stake in Apple. Since June 30, 2012, Apple's stock price has declined from $584 to $543, or 7 percent. During the same period, the Standard & Poor's 500 has risen 39 percent. “Our models were quicker to identify the problem than our analysts were willing to accept,” said Schwarte.
Investment management firms may like to talk about algorithms in their quantitative valuation models, not least because it is good marketing. However, managers may find it easier to look at a weekly price chart shown with a trend mean such as a 200-day moving average.
Take Apple, mentioned above. When a consistent trend eventually accelerates well above its MA, as Apple did in 4Q 2007, and more spectacularly in 2Q and 3Q 2012, it signals a period of investor euphoria which is unsustainable beyond the short term. Sharp reactions almost invariably follow in a process of mean reversion back to the MA.
Additionally, the bigger the overextension, the more likely it becomes that an eventual break well beneath the MA will also occur. Looking at the Apple chart above, you can see this in 3Q 2008 and 1Q 2013. Assuming a company remains viable, those big downside overextensions caused by panic are eventually viewed as buying opportunities.
Look at any medium to longer term trending chart; for perspective I suggest 10 year weekly charts with 200-day MAs, and you will see similar examples of overextensions and mean reversions.Back to top